Money, Inc., has no debt outstanding and a total market value of $275,000. Earni
ID: 2713817 • Letter: M
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Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percent lower. Money is considering a $99,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0
Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percent lower. Money is considering a $99,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 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. Calculate the percentage changes in ROE when the economy expands or enters a recession. Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession.Explanation / Answer
Money Inc. C1. Oustanding Shares 5,000 Equity Value 275,000 Recession Normal Expansion EBIT under different economic conditions 12,600 21,000 26,250 ROE before debt issue= EBIT/Equity value 4.58% 7.64% 9.55% C2. % Change in ROE from Normal Recession -40% Expansion 25% C3. After recapitalization outstanding shares 3,200 Equity Value 176,000 Debt amount 99,000 Interest @8% 7,920 Recession Normal Expansion EBIT under different economic conditions 12,600 21,000 26,250 Less interest (7,920) (7,920) (7,920) Income for Equity owners 4,680 13,080 18,330 ROE before After debt issue= Earning for Equity owners/Equity value 2.66% 7.43% 10.41% C4. % Change in ROE from Normal Recession -64.2% Expansion 40.1%
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