Pendergast, Inc., has no debt outstanding and a total market value of $180,000.

Question

Pendergast, Inc., has no debt outstanding and a total market value of $180,000. Earnings before interest and taxes, EBIT, are projected to be $23,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 30 percent lower. Pendergast is considering a $75,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 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 8.94 % Normal 12.78 % Expansion 15.33 % 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.) 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)) 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)) 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)) 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.) 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)) 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))

Explanation / Answer

a-1 Before any debt is issued in case of :

Recession EBIT / Net Income = 23000 - 30%*23000 = $16100

Normal EBIT / Net Income = 23000

Expansion EBIT / Net Income = 23000 + 20% * 23000 = $27600

ROE: Net Income/ Equity * 100

Recession = 16100 / 180000 * 100 = 8.94%

Normal = 23000 / 180000 * 100 = 12.78%

Expansion = 27600 / 180000 * 100 = 15.33%

a-2 % change in ROE:

Expansion = (15.33 - 12.78) / 12.78 * 100 = 19.95%

Recession = (8.94 - 12.78) / 12.78 * 100 = -30.05%

b-1 and b-2 & c-1 & c-2 are same as a-1 & a-2

c-3 In case company goes in for recapitalization:

Number of shares repurchased = $6000 / $180000 * $75000 = 2500 shares

Shares outstanding after recapitalization = 6000 - 2500 = 3500 shares

EBIT in all three situations shall be as calculated above in part a-1.

Recession EBIT = $16100

Normal EBIT = $23000

Expansion EBIT $27600

Net Income = EBIT - Interest

Interest = 7% * $75000 = $5250

Value of equity after recapitalization = $180000 - $75000 = $105000

ROE: Net Income/ Equity * 100

Recession = (16100 - 5250) / 105000 * 100 = 10.33%

Normal = (23000 -5250) / 105000 * 100 = 16.90%

Expansion = (27600 -5250) / 105000 * 100 = 21.29%

c-4 % change in ROE:

Expansion = (21.29 - 16.90) / 16.90 * 100 = 25.98%

Recession = (10.33 - 16.90) / 16.90 * 100 = -38.88%

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