Pendergast, Inc., has no debt outstanding and a total market value of $220,000.
ID: 2739793 • Letter: P
Question
Pendergast, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 20 percent lower. Pendergast is considering a $135,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 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. (Round your answers 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.)
% 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. (Round your answers 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. Round your answers 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. (Round your answers 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.)
% 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. (Round your answers 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 to Question a-1 >> Return on Equity
1.Recession:
EBIT = 40,000 – 40,000 *0.20 = $ 32,000
ROE = EBIT/ Shareholders Equity
ROE = 32,000 / 220,000
ROE = 14.55%
2.Normal :
EBIT = $ 40,000
ROE = EBIT/ Shareholders Equity
ROE = 40,000 / 220,000
ROE = 18.18%
3.Expansion:
EBIT = $ 40,000 + 40,000 * 0.10 = $ 44,000
ROE = EBIT/ Shareholders Equity
ROE = 44,000 / 220,000
ROE = 20%
Answer to Question a-2 >>> % Change in ROE
1.Recession :
% Change in ROE = Change in ROE/ROE *100
% Change in ROE = (14.55-18.18)/ 18.18*100
% Change in ROE = 3.63/18.18 *100
% Change in ROE = (-) 19.97%
2.Expansion :
% Change in ROE = Change in ROE/ROE *100
% Change in ROE = (20-18.18)/ 18.18*100
% Change in ROE = 1.82/18.18 *100
% Change in ROE = 10.01%
Answer to Part b-1
After the proposed re-capitalization:
Shareholder’s Equity = (220,000 – 135,000) = 85,000
Case 1: Recesion:
EBIT (20% lower) = 32,000
Less: Interest (135,000 * 4%) = 5,400
EBT = 26,600
ROE = EBT/ Shareholders Equity
ROE = 26,600 / 85,000
ROE = 31.29%
Case 2 : Normal :
EBIT = 40,000
Less: Interest (135,000 * 4%) = 5,400
EBT = 34,600
ROE = EBT/ Shareholders Equity
ROE = 34,600 / 85,000
ROE = 40.71%
Case: Expansion :
EBIT (10% Higher) = 44,000
Less: Interest (135,000 * 4%) = 5,400
EBT = 38,600
ROE = EBT/ Shareholders Equity
ROE = 38,600 / 85,000
ROE = 45.41%
Answer to Question b-2 >>> % Change in ROE
1.Recession :
% Change in ROE = Change in ROE/ROE *100
% Change in ROE = (31.29-40.71)/ 40.71*100
% Change in ROE = 9.42/40.71 *100
% Change in ROE = (-) 23.14%
2.Expansion :
% Change in ROE = Change in ROE/ROE *100
% Change in ROE = (45.41-40.71)/ 40.71*100
% Change in ROE = 4.70/40.71 *100
% Change in ROE = 11.55%
Answer to Question c-1 >>> ROE
Case 1: Recesion:
EBIT (20% lower) = 32,000
Less: Interest = 0
EBT = 32,000
Less: Tax @ 35%= 11,200
EAT = 20,800
ROE = EAT/ Shareholders Equity
ROE = 20,800 / 220,000
ROE = 9.45%
Case 2 : Normal :
EBIT = 40,000
Less: Interest = 0
EBT = 40,000
Less: Tax @ 35%= 14,000
EAT = 26,000
ROE = EAT/ Shareholders Equity
ROE = 26,000 / 220,000
ROE = 11.82%
Case: Expansion :
EBIT (10% Higher) = 44,000
Less: Interest = 0
EBT = 44,000
Less: Tax @ 35%= 15,400
EAT = 28,600
ROE = EAT/ Shareholders Equity
ROE = 28,600 / 220,000
ROE = 13%
Answer to Question C-2 >>> % Change in ROE
1.Recession :
% Change in ROE = Change in ROE/ROE *100
% Change in ROE = (9.45- 11.82)/ 11.82*100
% Change in ROE = 2.37/11.82 *100
% Change in ROE = (-) 20.05%
2.Expansion :
% Change in ROE = Change in ROE/ROE *100
% Change in ROE = (13-11.82)/ 11.82*100
% Change in ROE = 1.18/11.82 *100
% Change in ROE = 9.83%
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