Question

Kaelea, Inc., has no debt outstanding and a total market value
of $100,000. Earnings before interest and taxes, EBIT, are
projected to be $8,400 if economic conditions are normal. If there
is strong expansion in the economy, then EBIT will be 24 percent
higher. If there is a recession, then EBIT will be 31 percent
lower. The company is considering a $35,000 debt issue with an
interest rate of 6 percent. The proceeds will be used to repurchase
shares of stock. There are currently 4,000 shares outstanding.
Assume the company has a market-to-book ratio of 1.0.

**a.** Calculate return on equity, ROE, under each of
the three economic scenarios before any debt is issued, assuming no
taxes. **(Do not round intermediate calculations and enter
your answers as a percent rounded to 2 decimal places, e.g.,
32.16.)**

ROE | |

Recession | % |

Normal | % |

Expansion | % |

**b.** Calculate the percentage changes in ROE when
the economy expands or enters a recession, assuming no taxes.
**(A negative answer should be indicated by a
minus****sign. Do not round intermediate calculations
and enter your answers as a percent rounded to the nearest whole
number, e.g., 32.)**

%ΔROE | |

Recession | % |

Expansion | % |

Assume the firm goes through with the proposed recapitalization and
no taxes.

**c.** Calculate return on equity, ROE, under each of
the three economic scenarios after the recapitalization.
**(Do not round intermediate calculations and enter your
answers as a percent rounded to 2 decimal places, e.g.,
32.16.)**

ROE | |

Recession | % |

Normal | % |

Expansion | % |

**d.** Calculate the percentage changes in ROE for
economic expansion and 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.****)**

%ΔROE | |

Recession | % |

Expansion | % |

Assume the firm has a tax rate of 35 percent.

**e.** Calculate return on equity, ROE, under each of
the three economic scenarios before any debt is issued. Also,
calculate the percentage changes in ROE for economic expansion and
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.****)**

ROE | |

Recession | % |

Normal | % |

Expansion | % |

%ΔROE | |

Recession | % |

Expansion | % |

**f.** Calculate return on equity, ROE, under each of
the three economic scenarios after the recapitalization. Also,
calculate the percentage changes in ROE for economic expansion and
recession, assuming the firm goes through with the proposed
recapitalization. **(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.****)**

ROE | |

Recession | % |

Normal | % |

Expansion | % |

Answer #1

Kaelea, Inc., has no debt outstanding and a total market value
of $63,000. Earnings before interest and taxes, EBIT, are projected
to be $8,600 if economic conditions are normal. If there is strong
expansion in the economy, then EBIT will be 21 percent higher. If
there is a recession, then EBIT will be 34 percent lower. The
company is considering a $21,300 debt issue with an interest rate
of 8 percent. The proceeds will be used to repurchase shares of...

RAK, Inc., has no debt outstanding and a total market value of
$150,000. 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 15 percent higher. If
there is a recession, then EBIT will be 25 percent lower. RAK is
considering a $95,000 debt issue with an interest rate of 8
percent. The proceeds will be used to repurchase shares of stock....

RAK, Inc., has no debt outstanding and a total market value of
$180,000. Earnings before interest and taxes, EBIT, are projected
to be $25,000 if economic conditions are normal. If there is strong
expansion in the economy, then EBIT will be 10 percent higher. If
there is a recession, then EBIT will be 20 percent lower. RAK is
considering a $60,000 debt issue with an interest rate of 5
percent. The proceeds will be used to repurchase shares of stock....

RAK, Inc., has no debt outstanding and a total market value of
$200,000. Earnings before interest and taxes, EBIT, are projected
to be $30,000 if economic conditions are normal. If there is strong
expansion in the economy, then EBIT will be 18 percent higher. If
there is a recession, then EBIT will be 20 percent lower. RAK is
considering a $75,000 debt issue with an interest rate of 8
percent. The proceeds will be used to repurchase shares of stock....

Kaelea, Inc., has no debt outstanding and a total market value
of $75,000. Earnings before interest and taxes, EBIT, are projected
to be $9,400 if economic conditions are normal. If there is strong
expansion in the economy, then EBIT will be 24 percent higher. If
there is a recession, then EBIT will be 31 percent lower. The
company is considering a $22,500 debt issue with an interest rate
of 8 percent. The proceeds will be used to repurchase shares of...

Ghost, Inc., has no debt outstanding and a total market value of
$220,100. Earnings before interest and taxes, EBIT, are projected
to be $38,000 if economic conditions are normal. If there is strong
expansion in the economy, then EBIT will be 12 percent higher. If
there is a recession, then EBIT will be 23 percent lower. The
company is considering a $120,000 debt issue with an interest rate
of 5 percent. The proceeds will be used to repurchase shares of...

Ghost, Inc., has no debt outstanding and a total market value of
$262,500. Earnings before interest and taxes, EBIT, are projected
to be $42,000 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 27 percent lower. The
company is considering a $140,000 debt issue with an interest rate
of 5 percent. The proceeds will be used to repurchase shares of...

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...

Sunrise, Inc., has no debt outstanding and a total market value
of $284,900. Earnings before interest and taxes, EBIT, are
projected to be $44,000 if economic conditions are normal. If there
is strong expansion in the economy, then EBIT will be 18 percent
higher. If there is a recession, then EBIT will be 29 percent
lower. The company is considering a $150,000 debt issue with an
interest rate of 7 percent. The proceeds will be used to repurchase
shares of...

Kaelea, Inc., has no debt outstanding and a total market value
of $57,000. Earnings before interest and taxes, EBIT, are projected
to be $8,200 if economic conditions are normal. If there is strong
expansion in the economy, then EBIT will be 22 percent higher. If
there is a recession, then EBIT will be 33 percent lower. Kaelea is
considering a $20,700 debt issue with an interest rate of 8
percent. The proceeds will be used to repurchase shares of stock....

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