Question

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. The company is considering a $20,700 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 3,800 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.

Recession%

Normal%

Expansion%

b. Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes.

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.

Recession%

Normal%

Expansion%

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

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.

Recession%

Normal%

Expansion%

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.

Recession%

Normal%

Expansion%

Recession%

Expansion%

Answer 1

Kaelea	Expansion	Normal	Recession
EBIT	10,004	8,200	5,494
ROE	17.55%	14.39%	9.64%
% Change	22.0%		-33.0%
With Debt	Boom	Normal	Recession
EBIT	10,004	8,200	5,494
Interest	-1,656	-1,656	-1,656
Profits	8,348	6,544	3,838
ROE	23.00%	18.03%	10.57%
% Change	27.6%		-41.4%

ROE = Profits / Equity

Without debt, Equity = 57,000 and with debt, Equity = 57,000 - 20,700 = 36,300

Interest = 20,700 x 8% = 1,656

Kaelea	Expansion	Normal	Recession
EBIT	10,004	8,200	5,494
Taxes (35%)	-3,501	-2,870	-1,923
Profits	6,503	5,330	3,571
ROE	11.41%	9.35%	6.27%
% Change	22.0%		-33.0%
With Debt	Boom	Normal	Recession
EBIT	10,004	8,200	5,494
Interest	-1,656	-1,656	-1,656
EBT	8,348	6,544	3,838
Taxes (35%)	-2,922	-2,290	-1,343
Profits	5,426	4,254	2,495
ROE	14.95%	11.72%	6.87%
% Change	27.6%		-41.4%