Kaelea, Inc., has no debt outstanding and a total market value of $153,000. Earn

Question

Kaelea, Inc., has no debt outstanding and a total market value of $153,000. Earnings before interest and taxes, EBIT, are projected to be $9,500 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 30 percent lower. Kaelea is considering a $45,300 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,100 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.)

Explanation / Answer

Normal

ROE = Net Income/Total market value

ROE = 9500/153000

ROE = 6.21%

Recession

ROE = Net Income/Total market value

ROE = (9500-30%*9500)/153000

ROE = 4.35%

Expansion

ROE = Net Income/Total market value

ROE = (9500+20%*9500)/153000

ROE = 7.45%

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 minussign.)

Percentage changes in ROE in recession = (4.35-6.21)/6.21

Percentage changes in ROE in recession = -30%

Percentage changes in ROE in expansion = (7.45-6.21)/6.21

Percentage changes in ROE in expansion = -20%

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