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

Question

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 %

Normal %

Expansion %

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

Answer:a-1

Answer:a-2 Sensitivity Analysis: Normal to Recession

%ROE = (.09 - .12)/.12 = -25%

Sensitivity Analysis: Normal to Expansion

%ROE = (.13 - .12)/.12= 8.33%

Answer:b-1 If the firm goes forward with recapitalization, the new equity value will be: Equity = $240,000 - $140,000 or $100,000 [due to reduction of shares outstanding] So, the ROE for each state of the economy is: ROE = NI/$100,000

Answer:b-2

Sensitivity Analysis: Normal to Recession

%ROE = (.13 - .20)/.20 = -35%

Sensitivity Analysis: Normal to Expansion

%ROE = (.23 - .20)/.20= 15%

Particulars Recession Normal Expansion EBIT 21000 28000 31360 Less: Interest 0 0 0 EBT 21000 28000 31360 Net income 21000 28000 31360 Equity 240000 240000 240000 ROE =NI/Equity 0.09 0.12 0.13

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