Question

Ghost, Inc., has no debt outstanding and a total market value of $273,600. Earnings before interest and taxes, EBIT, are projected to be $43,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 17 percent higher. If there is a recession, then EBIT will be 28 percent lower. The company is considering a $145,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,600 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0 and the stock price remains constant.

Answer 1

c-1

ROE = EBIT*(1-tax rate)/Market value

Recession

ROE = EBIT*(1-recession impact%)*(1-tax rate)/market value

ROE=43000*(1-0.28)*(1-0.21)/273600

ROE=8.94

Normal

ROE = EBIT*(1-tax rate)/Market value

ROE=43000*(1-0.21)/273600

ROE=12.42

Expansion

ROE = EBIT*(1+Growth impact%)*(1-tax rate)/Market value

ROE=43000*(1+0.17)*(1-0.21)/273600

ROE=14.53

c-2

%age change in ROE for Recession

=(ROE recession/ROE normal-1)*100

=(0.0894/0.1242-1)*100

=-28%

%age change in ROE for Growth

=(ROE Growth/ROE normal-1)*100

=(0.1453/0.1242-1)*100

=16.99%

c-3

New market value = old market value-debt

=273600-145000

=128600

ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value

Recession

ROE = (EBIT*(1-recession impact%)-debt*interest %age)*(1-tax rate)/new market value

ROE=(43000*(1-0.28)-145000*0.06)*(1-0.21)/128600

ROE=13.67

Normal

ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value

ROE=(43000-145000*0.06)*(1-0.21)/128600

ROE=21.07

Expansion

ROE= (EBIT*(1+growth impact%)-debt*interest %age)*(1-tax rate)/new market value

ROE=(43000*(1+0.17)-145000*0.06)*(1-0.21)/128600

ROE=25.56

c-4

%age change in ROE for Recession

=(ROE recession/ROE normal-1)*100

=(0.1367/0.2107-1)*100

=-35.12%

%age change in ROE for Growth

=(ROE Growth/ROE normal-1)*100

=(0.2556/0.2107-1)*100

=21.31%