CH 13 drill Q 3 Part 2 Kaelea, Inc., has no debt outstanding and a total market

Question

CH 13 drill Q 3 Part 2

Kaelea, Inc., has no debt outstanding and a total market value of $106,000. Earnings before interest and taxes, EBIT, are projected to be $9,700 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 22 percent higher. If there is a recession, then EBIT will be 33 percent lower. Kaelea is considering a $30,600 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,300 shares outstanding. Assume Kaelea has a market-to-book ratio of 1.0.

Explanation / Answer

b. Percentage change of ROE in expansion and recession:

EBIT = 9,700

EBIT in case of expansion = 9,700 x 1.22 = $11,834

EBIT in case of recession = 9,700 x 0.67 = $6,499

ROE = EBIT / Market Value of Equity.

ROE in case of Expansion = 11,834 / 106,000 = 11.164150943%

ROE in case of Recession = 6,499/ 106,000 = 6.131132075%

Current ROE = 9,700 / 106,000 = 9.150943396%

% Change in Expansion = 11.164150943 - 9.150943396 / 9.150943396 = 22%

% Change in Recession = 9.150943396 - 6.131132075 / 9.150943396 = 33%

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