RAK, Inc., has no debt outstanding and a total market value of $250,000. Earning
ID: 2767644 • Letter: R
Question
RAK, Inc., has no debt outstanding and a total market value of $250,000. 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 20 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $105,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0. a1- Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.
a2- Calculate the percentage changes in ROE when the economy expands or enters a recession. Assume the firm goes through with the proposed recapitalization.
b1- Calculate the return on equity (ROE) under each of the three economic scenarios.
b2- Calculate the percentage changes in ROE when the economy expands or enters a recession. Assume the firm has a tax rate of 35 percent.
c1- Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.
c2- Calculate the percentage changes in ROE when the economy expands or enters a recession.
c3- Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.
c4- Given the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.
Explanation / Answer
A1
Particulars
Recession
Normal
Expansion
EBIT
32,000.00
40,000.00
48,000.00
Market Value
2,50,000.00
2,50,000.00
2,50,000.00
Return on Equity
12.80%
16.00%
19.20%
A2
Economy
Return on Equity
Absolute Change
Percentage Change over Normal
Recession
12.80%
-3.20%
-20.00%
Normal
16.00%
Expansion
19.20%
3.20%
20.00%
B1
Particulars
Recession
Normal
Expansion
EBIT
32,000.00
40,000.00
48,000.00
Less: Interest
4,200.00
4,200.00
4,200.00
EBT
27,800.00
35,800.00
43,800.00
Market Value before Buy Back
2,50,000.00
2,50,000.00
2,50,000.00
Less: Buy Back
1,05,000.00
1,05,000.00
1,05,000.00
Market Value after buy back
1,45,000.00
1,45,000.00
1,45,000.00
Return on Equity
19.17%
24.69%
30.21%
B2
Economy
Return on Equity
Absolute Change
Percentage Change over Normal
Recession
19.17%
-5.52%
-22.35%
Normal
24.69%
Expansion
30.21%
5.52%
22.35%
C1
Particulars
Recession
Normal
Expansion
EBIT
32,000.00
40,000.00
48,000.00
Less: Tax
11,200.00
14,000.00
16,800.00
EAT
20,800.00
26,000.00
31,200.00
Market Value
2,50,000.00
2,50,000.00
2,50,000.00
Return on Equity
8.32%
10.40%
12.48%
C2
Economy
Return on Equity
Absolute Change
Percentage Change over Normal
Recession
8.32%
-2.08%
-20.00%
Normal
10.40%
Expansion
12.48%
2.08%
20.00%
C3
Particulars
Recession
Normal
Expansion
EBIT
32,000.00
40,000.00
48,000.00
Less: Interest
4,200.00
4,200.00
4,200.00
EBT
27,800.00
35,800.00
43,800.00
Less: Tax
9,730.00
12,530.00
15,330.00
EAT
18,070.00
23,270.00
28,470.00
Market Value before Buy Back
2,50,000.00
2,50,000.00
2,50,000.00
Less: Buy Back
1,05,000.00
1,05,000.00
1,05,000.00
Market Value after buy back
1,45,000.00
1,45,000.00
1,45,000.00
Return on Equity
12.46%
16.05%
19.63%
C4
Economy
Return on Equity
Absolute Change
Percentage Change over Normal
Recession
12.46%
-3.59%
-22.35%
Normal
16.05%
Expansion
19.63%
3.59%
22.35%
A1
Particulars
Recession
Normal
Expansion
EBIT
32,000.00
40,000.00
48,000.00
Market Value
2,50,000.00
2,50,000.00
2,50,000.00
Return on Equity
12.80%
16.00%
19.20%
A2
Economy
Return on Equity
Absolute Change
Percentage Change over Normal
Recession
12.80%
-3.20%
-20.00%
Normal
16.00%
Expansion
19.20%
3.20%
20.00%
B1
Particulars
Recession
Normal
Expansion
EBIT
32,000.00
40,000.00
48,000.00
Less: Interest
4,200.00
4,200.00
4,200.00
EBT
27,800.00
35,800.00
43,800.00
Market Value before Buy Back
2,50,000.00
2,50,000.00
2,50,000.00
Less: Buy Back
1,05,000.00
1,05,000.00
1,05,000.00
Market Value after buy back
1,45,000.00
1,45,000.00
1,45,000.00
Return on Equity
19.17%
24.69%
30.21%
B2
Economy
Return on Equity
Absolute Change
Percentage Change over Normal
Recession
19.17%
-5.52%
-22.35%
Normal
24.69%
Expansion
30.21%
5.52%
22.35%
C1
Particulars
Recession
Normal
Expansion
EBIT
32,000.00
40,000.00
48,000.00
Less: Tax
11,200.00
14,000.00
16,800.00
EAT
20,800.00
26,000.00
31,200.00
Market Value
2,50,000.00
2,50,000.00
2,50,000.00
Return on Equity
8.32%
10.40%
12.48%
C2
Economy
Return on Equity
Absolute Change
Percentage Change over Normal
Recession
8.32%
-2.08%
-20.00%
Normal
10.40%
Expansion
12.48%
2.08%
20.00%
C3
Particulars
Recession
Normal
Expansion
EBIT
32,000.00
40,000.00
48,000.00
Less: Interest
4,200.00
4,200.00
4,200.00
EBT
27,800.00
35,800.00
43,800.00
Less: Tax
9,730.00
12,530.00
15,330.00
EAT
18,070.00
23,270.00
28,470.00
Market Value before Buy Back
2,50,000.00
2,50,000.00
2,50,000.00
Less: Buy Back
1,05,000.00
1,05,000.00
1,05,000.00
Market Value after buy back
1,45,000.00
1,45,000.00
1,45,000.00
Return on Equity
12.46%
16.05%
19.63%
C4
Economy
Return on Equity
Absolute Change
Percentage Change over Normal
Recession
12.46%
-3.59%
-22.35%
Normal
16.05%
Expansion
19.63%
3.59%
22.35%
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