RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning
ID: 2490913 • Letter: R
Question
RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. RAK is considering a $140,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 12,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.
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.)
Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts 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.)
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.)
Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts 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.)
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.)
Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts 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.)
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.)
Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))
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.)
Explanation / Answer
a1 If there is no debt EBIT =Net Income Shareholders Equity EBIT = NI ROE = NI/Shareholder's Equity Normal $240,000 $28,000 11.67 Expansion $240,000 $31,360 [$28000*1.12] 13.07 Recession $240,000 21000 [$28000*0.75] 8.75 a2 % change in ROE Working Recession 25.00 [11.67-8.75]/11.67 [ROE in Normal-ROE in recession]/ROE in Normal Expansion 12.00 [13.07-11.67]/11.67 [ROE in expansion -ROE in Normal]/ROE in Normal b1 EBIT Interest[$140000*6%] Net Income Shareholders Equity [$240000-$140000] ROE = NI/Shareholder's Equity Normal $28,000 8400 $19,600 100000 19.6 Expansion $31,360 8400 $22,960 100000 22.96 Recession 21000 8400 $12,600 100000 12.6 b2 % change in ROE Working Recession 35.71 [19.6-12.6]/19.6 [ROE in Normal-ROE in recession]/ROE in Normal Expansion 17.14 [22.96-19.6]/19.6 [ROE in expansion -ROE in Normal]/ROE in Normal c1 Shareholders Equity EBIT EAT = EBIT (1-0.35) ROE = NI/Shareholder's Equity Normal $240,000 $28,000 18200 7.58 Expansion $240,000 $31,360 [$28000*1.12] 20384 8.49 Recession $240,000 21000 [$28000*0.75] 13650 5.69 c2 % change in ROE Working Recession 25.00 [7.58-5.69]/7.58 [ROE in Normal-ROE in recession]/ROE in Normal Expansion 12.00 [8.49-7.58]/7.58 [ROE in expansion -ROE in Normal]/ROE in Normal c3 EBT[worked out in B1 EAT = EBIT (1-0.35) Net Income Shareholders Equity [$240000-$140000] ROE = NI/Shareholder's Equity Normal $19,600 12740 $6,860 100000 6.86 Expansion $22,960 14924 $8,036 100000 8.036 Recession 12600 8190 $4,410 100000 4.41 c4 % change in ROE Working Recession 35.71 [6.86-4.41]/6.86 [ROE in Normal-ROE in recession]/ROE in Normal Expansion 17.14 [8.034-6.86]/6.86 [ROE in expansion -ROE in Normal]/ROE in Normal
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