Kaelea, Inc., has no debt outstanding and a total market value of $75,000. Earni

Question

Kaelea, Inc., has no debt outstanding and a total market value of $75,000. Earnings before interest and taxes, EBIT, are projected to be $9,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. Kaelea is considering a $22,500 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Assume Kaelea has a market-to-book ratio of 1.0.

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).)

(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).)

Explanation / Answer

A./

IF THE FIRM GOES FORWARD WITH RECAPITALIZATION, THE NEW EQUITY VALUE WILL BE:

EQUITY = $75000 - $22500

OR $52500 [DUE TO REDUCTION OF SHARES OUTSTANDING]

ROE = EBT / EQUITY

($4686 / $52500)

=$0.09

($7600 / $52500)

=$0.14

($9856 / $52500)

=$0.19

B./

SENSITIVITY ANALYSIS: NORMAL TO RECESSION

%ROE = (0.09 - 0.14) /0.14

= -0.3571 OR -35.71%

SENSITIVITY ANALYSIS: NORMAL TO EXPANSION

%ROE = (0.19 - 0.14) /0.14

= 0.3571 OR 35.71%

DESCRIPTION RECESSION NORMAL EXPANSION EBIT $6486 $9400 $11656 LESS INTEREST (422500 * 8%) $1800 $1800 $1800 EBT $4686 $7600 $9856

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