Question

RAK, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $105,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0. a-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession Normal Expansion a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) % change in ROE Recession Expansion Assume the firm goes through with the proposed recapitalization b-1 Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession Normal Expansion b-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) % change in ROE Recession Expansion Assume the firm has a tax rate of 35 percent. C-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession Normal Expansion c-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) % change in ROE Recession Expansion C-3 Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession Normal Expansion C-4 Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) % change in ROE Recession Expansion

Answer 1

solution: a 1 economic condition EBITENI ROEN NI/250000 recession 32000 Normal 40000 expansion 48000 12.80% 16.00% 19.20% a2 economic condition %A ROE calculation recession -20.00% (12.8-16)/16 expansion 20.00% (19.2-16)/16 bi economic condition EBIT interest 105000*0.04 recession 32000 Normal 40000 expansion 48000 NI=EBIT-Int ROE= NI/(250000-105000) 4200 27800 19.17% 4200 35800 24.69% 4200 43800 30.21% b2 economic condition %A ROE calculation recession -22.35% (19.17-24.69)/24.69 expansion 22.35% (30.21-24.69)/24.69

c1 economic condition EBIT TAX =EBIT*35% recession Normal expansion 320001 40000 48000 11,200.00 14,000.00 16,800.00 NI=EBIT-tax ROE= NI/250000 20,800.00 26,000.00 31,200.00 8.32% 10.40% 12.48% c2 economic condition %AROE calculation recession -20.00% (8.32-10.4)/10.4 expansion 20.00% (12.48-10.4)/10.4 <3 EDT - EN - rav=for-3* EBT = EBIT-TAX =EBT* 35% Ear=Cior to face economic condition EBIT interest 105000*0.04 recession 32000 Normal 40000 expansion 48000 4200 4200 42001 27800 358001 438001 9,730 12,530 15,330 EAT=EBT-Tax ROE= NI/(250000-105000) 18,070 12.46% 23,270 16.05% 28,470 19.63% c4 economic condition %A ROE calculation recession -22.35% (12.46-16.05)/16.05 expansion 22.35% (19.63-16.05)/16.05 EBIT=Earning before Interest and tax NI=Net income EBT=Earning before tax EAT=Earning after tax