Question

Castle, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $36,000 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 25 percent lower. The firm is considering a debt issue of $155,000 with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 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.

Answer 1

a-1) Using the following Data: debt issue EBIT (Normal $240,000 $36,000 change in case of expansion % change in case of recession Tax rate Using the above data, since debt and taxes are zero, therefore net income can be calculated as following 25% 10 EBIT Interest Expense Income Before Tax Tax Expense Net Income $27,000 $36,000 $43,200 $27,000 $36,000 $43,200 $0 $27,000 F12-G12 $0$36,000 $0 $43,200 12 Recession Normal Expansion 14 15 16 17 0 Return on Equity calculation: Return on Equity is given by following formula: Net Income- PreferredDividend 19 Return on Equity - AverageShareholde's Equity Since preferred dividend is zero, Return on Equity can be calculated as follows: 24 Net Income Shareholder's Equity Return on Equit 26 27 Recession Normal Expansion $27,000 $36,000 $43,200 $240,000 $240,000 $240,000 11.25%-D25/E25 15.00% 18.00% 29 a-2) % change in ROE 25.00%)-(F25-F26)/F26 20.00% 32 Recession Expansion

b-1) Market Value before Debt Issue Debt Issued Market Value after debt Issue 35 $240,000 $155,000 $85,000 36 38 39 Interest Rate Interest Expense Tax Rate $9,300 41 42 43 Using the above data, net income can be calculated as following: 45 EBIT Interest Expense Income Before Tax Tax Expense Net Income $27,000 $36,000 $43,200 $9,300 $9,300 $9,300 $17,700 $26,700 $33,900 $0 $17,700 F47-G47 $0$26,700 $0$33,900 47 Recession Normal Expansion 49 Return on Equity calculation: Return on Equity is given by following formula: 52 Net Income- PreferredDividend 54 Return on Equity - AverageShareholde's Equity 57 Since preferred dividend is zero, Return on Equity can be calculated as follows: 59 Net Income Shareholder's Equity Return on Equit $85,000 $85,000 $85,000 D60/E60 Recession Normal Expansion $17,700 $26,700 $33,900 20.82% 31.41% 39.88% 61 63 b-2) % change in ROE 33.71%)-(F60-F61)/F61 26.97% Recession Expansion
Formula sheet

A	B	C	D	E	F	G	H	I	J
2		a-1)
3		Using the following Data:
4		Market Value of Equity before debt issue	240000
5		EBIT (Normal)	36000
6		% change in case of expansion	0.2
7		% change in case of recession	-0.25
8		Tax rate	0
9		Using the above data, since debt and taxes are zero, therefore net income can be calculated as following:
10
11			EBIT	Interest Expense	Income Before Tax	Tax Expense	Net Income
12		Recession	=D13*(1+D7)	0	=D12-E12	=F12*$D$8	=F12-G12	=F12-G12
13		Normal	=D5	0	=D13-E13	=F13*$D$8	=F13-G13
14		Expansion	=D5*(1+D6)	0	=D14-E14	=F14*$D$8	=F14-G14
15
16		Return on Equity calculation:
17		Return on Equity is given by following formula:
18
19
20
21
22		Since preferred dividend is zero, Return on Equity can be calculated as follows:
23
24			Net Income	Shareholder's Equity	Return on Equity
25		Recession	=H12	=$D$4	=D25/E25	=D25/E25
26		Normal	=H13	=$D$4	=D26/E26
27		Expansion	=H14	=$D$4	=D27/E27
28
29		a-2)
30
31			% change in ROE
32		Recession	=(F25-F26)/F26	=(F25-F26)/F26
33		Expansion	=(F27-F26)/F26
34
35		b-1)
36		Market Value before Debt Issue	240000
37		Debt Issued	155000
38		Market Value after debt Issue	=D36-D37
39
40		Interest Rate	0.06
41		Interest Expense	=D37*D40
42		Tax Rate	0
43
44		Using the above data, net income can be calculated as following:
45
46			EBIT	Interest Expense	Income Before Tax	Tax Expense	Net Income
47		Recession	=D12	=$D$41	=D47-E47	=F47*$D$42	=F47-G47	=F47-G47
48		Normal	=D13	=$D$41	=D48-E48	=F48*$D$42	=F48-G48
49		Expansion	=D14	=$D$41	=D49-E49	=F49*$D$42	=F49-G49
50
51		Return on Equity calculation:
52		Return on Equity is given by following formula:
53
54
55
56
57		Since preferred dividend is zero, Return on Equity can be calculated as follows:
58
59			Net Income	Shareholder's Equity	Return on Equity
60		Recession	=H47	=$D$38	=D60/E60	=D60/E60
61		Normal	=H48	=$D$38	=D61/E61
62		Expansion	=H49	=$D$38	=D62/E62
63
64		b-2)
65
66			% change in ROE
67		Recession	=(F60-F61)/F61	=(F60-F61)/F61
68		Expansion	=(F62-F61)/F61
69