Kaelea, Inc., has no debt outstanding and a total market value of $106,000. Earn
ID: 2720503 • Letter: K
Question
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.
Requirement 1:
(a) 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 Recession % Normal % Expansion %
(b) 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.) %ROE Recession % Expansion %
Requirement 2: Assume the firm goes through with the proposed recapitalization and no taxes.
(a) Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) ROE Recession % Normal % Expansion %
(b) 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).) %ROE Recession % Expansion %
Requirement 3: Assume the firm has a tax rate of 35 percent.
(a) 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).) ROE Recession % Normal % Expansion % %ROE Recession % Expansion %
(b) 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).) ROE Recession % Normal % Expansion % %ROE Recession % Expansion %
Explanation / Answer
REQUIREMENT 1
a)
_______________________________________________________________________________________
NORMAL EXPANSION RECESSION
Net Worth or Equity 106,000 106,000 106,000
EBIT 9,700 11,834 6,499
ROE = EBIT/EQUITY x 100 9.15% 11.16% 6.13%
_________________________________________________________________________________
RECESSION NORMAL EXPANSION
ROE 6.13% 9.15% 11.16%
b) Percentage change in ROE when economy enters expansion
= % increasse /Normal % x 100
= 11.16-9.15/9.15 x 100 = 2.01/9.15 x 100 = 21.97%
Percentage change in ROE when economy enters in Recession
= % decrease/Normal % x 100
= 9.15 - 6.13 /9.15 x 100
= 3.02/9.15 x 100 = 33%
Hence, change in ROE in Recession = 33% fall ; Change in ROE in expansion = 21.97% increase
REQUIREMENT - 2
a). ____________________________________________________________________________________ ____
NORMAL EXPANSION RECESSION
Present EBIT 9,700 11,834 6,499
Less: Interest on Debt (7% of 30,600) 2,142 2,142 2,142
Earnings after interest (EAT) 7,558 9,692 4,357
Equity after purchase of stock
(106,000 - 30,600) 75,400 75,400 75,400
ROE (EAT/EQUITY) 10.02% 12,85% 5.78%
Hence, ROE Recession = 5.78%
ROE Normal =10.02%
ROE Expansion =12.85%
b) Percentage change in ROE in Recession = % decreae/Normal % x 100
= 10.02 - 5.78/10.02 x 100
= 4.24/10.02 x100
= 42.31% fall
Percentage increase in ROE in Expansion= % increase/Normal % x 100
= 12.85% - 10.02% /10.02% x 100
= 2.83/10.02 x 100
= 28.24%
REQUIREMENT - 3:
a).
_______________________________________________________________________________________
NORMAL EXPANSION RECESSION
EQUITY (NO DEBT) 106,000 106,000 106,000
EBIT 9,700 11,834 6,499
Less: Tax @35% 3,395 4,142 2,275
Earnings after tax (EAT) 6,305 7,692 4,224
ROE (EAT/EQUITY) 5.95% 7.26% 3.98%
ROE : RECESSION = 3.98%
ROE : NORMAL = 5.95%
ROE : EXPANSION = 7.26%
Percentage change in ROE in recession = % decrease/Normal% x 100
= 5.95 - 3.98/5.96 x 100
= 1.97/5.95 x 100
= 33.11% fall
Percentage change in ROE in expansion = % increase/Normal% x 100
= 7.26 - 5.95/5.95 x 100
= 1.31/5.95 x 100
= 22.02% increase
b)
______________________________________________________________________________________
NORMAL EXPANSION RECESSION
EQUITY AFTER RAISING DEBT
AND PURCHASE OF STOCK (106,000 - 30,600) 75,400 75,400 75,400
EBIT 9,700 11,834 6,499
Less: Interest @7% on 30,600 2,142 2,142 2,142
Earnings before tax (EBT) 7,558 9,692 4,357
Tax @ 35% on EBT 2,645 3,392 1,525
Earnings after tax (EAT) 4,913 6,300 2,832
ROE = EAT/EQUITY 6.52% 8.36% 3.76%
ROE: RECESSION = 3.76%
ROE: NORMAL = 6.52%
ROE: EXPANSION = 8.36%
Percentage change in ROE in recession = % decrease/normal % x 100
= 6.52 - 3.76 /6.52 x 100
= 2.76/6.52 x 100
= 42.33% fall
Percetnage change in ROE in expansion = %increase /Normal % x 100
= 8.36 - 6.52/6.52 x 100
= 1.84/6.52 x 100
= 28.22% increase
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