Question

Castle, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 30 percent lower. The firm is considering a debt issue of $70,000 with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 shares outstanding. Ignore taxes for questions a and b. Assume the stock price remains constant.

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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

  

	% 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. (A negative answer 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

	% 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. (A negative answer 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	%

Answer 1

a. 1.

	ROE
Recession	8.4 %
Normal	12 %
Expansion	13.8 %

a. 2 .

	% change in ROE
Recession	- 30 %
Expansion	15 %

b. 1.

	ROE
Recession	9.15 %
Normal	14.69 %
Expansion	17.46 %

b.2.

	% change in ROE
Recession	- 38 %
Expansion	19 %

c. 1.

	ROE
Recession	5.46 %
Normal	7.8 %
Expansion	8.97 %

c. 2.

	% change in ROE
Recession	- 30 %
Expansion	15 %

c. 3

	ROE
Recession	5.95 %
Normal	9.55 %
Expansion	11.35 %

c.4

	% change in ROE
Recession	- 38 %
Expansion	19%