Question

Ghost, Inc., has no debt outstanding and a total market value of $450,000. Earnings before interest and taxes, EBIT, are projected to be $57,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 16 percent higher. If there is a recession, then EBIT will be 24 percent lower. The company is considering a $215,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 9,000 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.

  

a-1.	Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
b-1.	Assume the firm goes through with the proposed recapitalization. Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
b-2.	Assume the firm goes through with the proposed 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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

	Expansion	Normal	Recession
EBIT	66,120	57,000	43,320
Less: Interest	0	0	0
EBT	66,120	57,000	43,320
Equity	450,000	450,000	450,000
ROE	14.69%	12.67%	9.63%
a-2 % change
Expansion = 14.69%-12.67% = 2.02%
Recession = -3.04%
b-1
	Expansion	Normal	Recession
EBIT	66,120	57,000	43,320
Less: Interest	17200	17200	17200
EBT	48,920	39,800	26,120
Equity	235,000	235,000	235,000
ROE	20.82%	16.94%	11.11%
b-2 Change
Expansion = 3.88%
Recession = -5.83%