RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning
ID: 2780454 • Letter: R
Question
RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.
RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.
c-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession Normal Expansion c-2 Calculate the percentage changes in ROE w hen the economy expands or enters a recession (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) % change in ROE Recession Expansion c-3 Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession Normal Expansion 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)) Recession ExpansionExplanation / Answer
The tax rate is not mentioned. I assume it to be 35%.
ROE = Profits / Equity
Before recap, Equity = 240,000 and after recap, equity = 240,000 - 150,000 = 90,000
After recap, interest = Debt x Interest rate = 150,000 x 8% = 12,000
RAK Expansion Normal Recession EBIT 30,680 26,000 20,800 Taxes (35%) -10,738 -9,100 -7,280 Profits 19,942 16,900 13,520 ROE 8.31% 7.04% 5.63% % Change 18.0% -20.0% With Debt Boom Normal Recession EBIT 30,680 26,000 20,800 Interest -12,000 -12,000 -12,000 EBT 18,680 14,000 8,800 Taxes (35%) -6,538 -4,900 -3,080 Profits 12,142 9,100 5,720 ROE 13.49% 10.11% 6.36% % Change 33.4% -37.1%Related Questions
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