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.

Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued, assuming no taxes. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).)

Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.)

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).)

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 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.

Explanation / Answer

Return on Equity (ROE) or return on capital is the ratio of net income of a business during a year to its stockholders equity during that year. It is a measure of profitability of stockholder’s investment. The formula to calculate Return on Equity is:

                                ROE= Annual Net Income / Average stockholder’s Equity

ROE is an important measure of profitability of the company. Higher ROE means company is efficient in generating income on new investment.

REQUIREMENT 1

Market value is $75000

Here we will take market value as shareholder’s equity

During expansion it is given that EBIT will be 24% higher. So it comes to                                         $9400 * 1.24=$11656

During Recession it will be :$9400 * (1-.31) = $6486

Hence ROE under all the three scenarios will be:

$6486/$75000 *100= 8.65%

$9400/$75000 *100 =12.53%

$11656/$75000 *100=15.54%

                Percentage change in ROE during Expansion = 15.54-12.53/12.53 =24.02%

                Percentage change in ROE during Recession = 8.65-12.53/12.53 =-30.97%

REQUIREMENT 2

When the firm goes for Recapitalization

There is debt issue of $22500 with an interest rate of 8% assuming no taxes.

Hence total interest comes to :$22500 *8% =$1800

So EBT = $9400-1800$= $7600(under Normal)

Under Recession =$6486-$1800= $4686

Under Expansion= $11656-$1800= $9856

If the firm goes forward with recapitalization then the new equity value will be

=$75000-$22500 = $52500

Hence ROE will be

Recession

Normal

Expansion

4686/52500 =8.93%

7600/52500= 14.48%

9856/52500= 18.77%

(B) % change in ROE from normal to recession =(.0893-.1448)/.1448 = -.3833 or -38.33%

      %change in ROE from Normal to Expansion = (.1877-.1448)/.1448 = .2963 or 29.63%

REQUIREMENT 3

(a)Calculation showing ROE before any debt is issued with a tax rate of 35%

Recession

Normal

Expansion

EBIT

$6486

$9400

$11656

LESS:Taxes @ 35%

2270

3290

4080

EBI

4216

6110

7576

Hence ROE will be:

Recession

Normal

Expansion

4216/75000=5.62%

6110/75000= 8.15%

7576/75000= 10.10%

% change in ROE from normal to recession =(.0562-.0815)/ .0815= - 31.04%

%change in ROE from normal to expansion =(.1010-.0815)/ .0815 =23.93%

(B) If the company goes for recapitalization and tax rates are 35 % then,

Recession($)

Normal( $)

Expansion ($)

EBIT

6486

9400

11656

Less: Interest

1800

1800

1800

EBT

4686

7600

9856

Less:Taxes @35%

1640

2660

3450

NET INCOME

3046

4940

6406

ROE

3046/52500=5.80%

4940/52500= 9.41%

6406/52500=12.20%

% change in ROE from normal to recession =(.0580-.0941)/.0941= -38.36%

% change in ROE from normal to expansion= (.1220- .0941)/.0941=29.65%

Hence , the answer.

• Recession

• Normal

• Expansion

$6486/$75000 *100= 8.65%

$9400/$75000 *100 =12.53%

$11656/$75000 *100=15.54%

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