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.

Requirement 3:

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. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

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. (Do not round intermediate calculations Negative amounts should be indicated by a minus sign. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Explanation / Answer

a) ROE:

Recession = 9500 * (1 - .30) * (1 - .35) / 153000 = 2.82%

Normal = 9500 * (1 - .35) / 153000 = 4.03%

Expansion = 9500 * (1 + .20) * (1 - .35) / 153000 = 4.84%

% change:

Recession = 2.82% / 4.03% - 1 = 30%

Expansion = 4.84% / 4.03% - 1 = 20%

b) ROE after recapitalization:

Recession = (9500 * (1 - .30) - (45300*.05)) * (1 - .35) / (153000 - 45300) = 2.65%

Normal = (9500 - (45300*.05)) * (1 - .35) / (153000 - 45300) = 4.37%

Expansion = (9500 * (1 + .20) - (45300*.05)) * (1 - .35) / (153000 - 45300) = 5.51%

% change:

Recession = 2.65% / 4.37% - 1 = 39.36%

Expansion = 5.51% / 4.37% - 1 = 26.09%

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