Kaelea, Inc., has no debt outstanding and a total market value of $100,000. Earn

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. Kaelea 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 Kaelea 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, assuming no taxes. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).)

Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.)

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. Kaelea 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 Kaelea has a market-to-book ratio of 1.0.

Explanation / Answer

Requirement 1:

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. Round your answers to 2 decimal places (e.g., 32.16).)

ROE = Net Income/Total Equity

Normal

ROE = Net Income/Total Equity

ROE = 8400/100000

ROE = 8.40%

Recession

ROE = Net Income/Total Equity

ROE = (8400-31%*8400)/100000

ROE = 5.796%

Expansion

ROE = Net Income/Total Equity

ROE = (8400+24%*8400)/100000

ROE = 10.416%

Answer

Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.)

Recession

Changes in ROE = 5.796 - 8.40

Changes in ROE = - 2.604%

Percentage Change in ROE = -2.604/8.40 = -31%

Expansion

Changes in ROE = 10.416 - 8.40

Changes in ROE = 2.016%

Percentage Change in ROE = 2.016/8.40 = 24%

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. Round your answers to 2 decimal places (e.g., 32.16).)

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