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

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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.

Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also, 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).)

Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming the firm goes through with the proposed recapitalization. (Do not round intermediate calculationsNegative amounts should be indicated by a minus sign. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

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 3: Assume the firm has a tax rate of 35 percent. (a)

Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also, 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).)

(b)

Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming the firm goes through with the proposed recapitalization. (Do not round intermediate calculationsNegative amounts should be indicated by a minus sign. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Requirement 3 Assume the firm has a tax rate of 35 percent (a) Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued Also, 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).) ROE Recession Normal Expansion Recession Expansion (b) Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization Also, calculate the percentage changes in ROE for economic expansion and recession, assuming the firm goes through with the proposed recapitalization. (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).) ROE Recession Normal Expansion Recession Expansion

Explanation / Answer

a)

Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE :

ROE = NI/$75,000

The ROE for each state of the economy under the current capital structure and no taxes is :

b)

If the company undertakes the proposed recapitalization, the new equity value will be

Equity = $75,000 - 22,500 = $52,500

So, the ROE for each state of the economy is

If $22,500 worth of debt is raised to retire stock, then you will be buying back $22,500/$15 or 1,500 shares. So, after recapitalization there will be 5,000 -1,500 or 3,500 shares outstanding

EBIT will be reduced by the amount of the interest on $22,500 in debt or $22,500 * 0.08 = $1,800

Recession Normal Expansion ROE 6486 / 75,000 = 0.0864 9,400 / 75,000 = 0.1253 11,656 / 75,000 = 0.1554 %D ROE - 31% +24%

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