RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning

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RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 12 percent higher. If there is a recession, then EBIT will be 25 percent lower. RAK is considering a $140,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 12,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0. a-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession 1.14 % Normal 1.52 % Expansion 1.70 % a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) % change in ROE Recession % Expansion % Assume the firm goes through with the proposed recapitalization. b-1 Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession % Normal % Expansion % b-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) % change in ROE Recession % Expansion % Assume the firm has a tax rate of 35 percent. c-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession % Normal % Expansion % c-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) % change in ROE Recession % Expansion % c-3 Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession % Normal % Expansion % c-4 Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) % change in ROE Recession % Expansion %

Explanation / Answer

Ans;

Normal Recession Expansion EBIT $28,000 $21,000 $31,360 Number of shares 12000 12000 12000 EAT 18200 13650 20384 EPS 1.52 1.14 1.70 Percentage change -25.00% 11.84% Number of shares 12000 Weight Market Price/share $20.00 Total value 240000 100% Debt issue $1,40,000 Number of shares to be repurchased 7,000 Outstanding shares after repurchase 5,000 Increase interest expense $8,400.00 Stockholder's equity 125000 Normal Recession Expansion EBIT $28,000 $21,000 $31,360 Less: Interest $8,400 $6,000 $6,000 EBT $19,600 $15,000 $25,360 Less:Tax $6,860 $5,250 $8,876 EAT $12,740 $9,750 $16,484 Number of shares 5,000 5,000 5,000 EPS 2.55 1.95 3.30 Percentage change 23.53% 29.41%

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