RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning
ID: 2740195 • Letter: R
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 $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 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 -20 % Expansion 18 % 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
Total market value of equity 240000 Total market value of equity after debt issue 90000 Since Market to book ratio is 1 this value is to be used in ROE calculation Without taxes With taxes @35% EBIT 26000 EBIT(26000-(35%*26000)) 16900 Expansion - 18% higher 30680 (26000*118%) Expansion - 18% higher 19942 (30680-(35%*30680) recession - 20% lower 20800 (26000*80%) recession - 20% lower 13520 (20800-(35%*20800) Debt issue @ 8% 150000 Interest Expense 12000 (150000*8%) After debt issue-EBIT After debt issue-EBIT EBIT(26000-12000) 14000 EBIT(14000-(35%*14000) 9100 Expansion - 18% higher 18680 (30680-12000 Expansion - 18% higher 12142 (18680-(35%*18680)) recession - 20% lower 8800 (20800-12000) recession - 20% lower 5720 (8800-(35%*8800) Return on equity = Net Income/Total equity a-1 Normal 10.83% (26000/240000) Expansion 12.78% (30680/240000) Recession 8.67% (20800/240000) a-2( Change in ROE) Normal-expansion 18.01% (12.78-10.83)/10.83 Normal-recession -19.94% b-1 Normal 15.56% (14000/90000) Expansion 20.76% (18680/90000) Recession 9.78% (8800/90000) b-2 Normal-expansion 33.42% (20.76-15.56)/15.56 Normal-recession -37.15% c-1 Normal 7.04% (16900/240000) Expansion 8.31% (19942/240000) Recession 5.63% (13520/240000) C-2 Normal-expansion 18.04% Normal-recession -20.03% C-3 Normal 10.11% Expansion 13.49% Recession 6.36% C-4 Normal-expansion 33.43% Normal-recession -37.09%
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