***IT\'S ACTUALLY INSANE THAT NOT ONE PERSON HAS ANSWERED THIS CORRECTLY. 8TH TI

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***IT'S ACTUALLY INSANE THAT NOT ONE PERSON HAS ANSWERED THIS CORRECTLY. 8TH TIME POSTING THIS. PLEASE ANSWER THIS CORRECTLY AND LABEL THE ANSWER TO EACH PART!!!!!!

Music City, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 25 percent lower. The company is considering a $48,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 20,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.

Calculate the percentage changes in ROE when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

c-2.

% change in ROE Recession % Expansion %

c-3.

ROE Recession % Normal % Expansion %

c-4.

% change in ROE Recession % Expansion %

Explanation / Answer

2. Market Value of Firm = $240000 = Shareholder's Equity (since the firm is debt free)

Also, market to book value ratio is 1, which means that shareholder's equity value = book value of equity = market value of equity.

Further, the firm is considering a debt issue but has not yet issued the debt. Hence, changes in ROE for different economic conditions would be calculated using the book value of equity and debt free EBIT value.

ROE = Net Profit / Book Value of Equity and Net Profit = EBIT - Interest Expense - Taxes

Since, the firm is debt free as of now and taxes have been ignored, the interest expenses and taxes would be zero making the net profit equal to the EBIT

% ROE Change in this part has to be calculated with relative to normal (current) economic conditions for (i) Recession and (ii) Expansion

(i) ROE ( in normal condition) = Net Income / Shareholder's Equity = 0.1167

ROE ( recession) = Net Income (under recession) / Shareholder's Equity = 21000 / 240000 = 0.0875

Therefore, % change in ROE = (0.0875 - 0.1167 / 0.1167) x 100 = -25.0214%

(ii) ROE (in normal condition) = Net Income/ Shareholder's Equity = 0.1167

ROE (Expansion) = Net Income (Expansion) / Shareholder's Equity = 30800 / 240000 = 0.1283

%Change in ROE = (0.1283 - 0.1167 / 0.1167) x 100 = 9.968%

3. If the firm goes ahead with the recapitalization process which is essentialy repurchase of shares to reduce the shareholder's equity base of 20000 outstanding shares worth $240000.

Debt Raised = 48000$ at 4% interest. Annual Interest Expense = Interest Rate x Debt = $1920

The debt proceeds would be used to repurchase outstanding shares and reduce their number.

Market Value of Equity = $240000 , No. of Outstanding Shares = 20000

Therefore, price of one share = Market Value of Equity / No. of Outstanding Shares = 240000/ 20000 = $12

Number of shares which can be purchased using debt proceeds = Debt Proceed / Share Price = 48000 / 12 = 4000 shares

After repurchase , number of shares outstanding = 20000 - 4000 =16000

Economic Condition: Normal

EBIT = $ 28000 , Annual Interest Expense = $1920 and Tax = 0

Net Income = EBIT - Annual Interest Expense - Tax = 28000 - 1920 - 0 = $26080

Shareholder's Equity (post repurchase) = 16000

Book value of equity (post repurchase) = Share price x shareholder's equity = 12 x 16000 = $192000

Therefore, ROE = Net Income / Book Value of Equity (post repurchase) = 26080 / 192000 = 0.1358 OR 13.58%

Economic Condition: Expansion

EBIT = $ 30800 , Annual Interest Expense = $1920 and Tax = 0

Net Income = EBIT - Annual Interest Expense - Tax = 30800 - 1920 - 0 = $28880

Shareholder's Equity (post repurchase) = 16000

Book value of equity (post repurchase) = Share price x shareholder's equity = 12 x 16000 = $192000

Therefore, ROE = Net Income / Book Value of Equity (post repurchase) = 28880 / 192000 = 0.1504 OR 15.04%

Economic Condition: Recession

EBIT = $ 21000 , Annual Interest Expense = $1920 and Tax = 0

Net Income = EBIT - Annual Interest Expense - Tax = 21000 - 1920 - 0 = $ 19080

Shareholder's Equity (post repurchase) = 16000

Book value of equity (post repurchase) = Share price x shareholder's equity = 12 x 16000 = $192000

Therefore, ROE = Net Income / Book Value of Equity (post repurchase) = 19080 / 192000 = 0.0993 OR 9.93%

4. Post Recapitalization:

(i) ROE (Normal Condition) = 0.1358 , ROE (Recession) = 0.09937

Therefore, % change in ROE = ( 0.09937 - 0.1358 / 0.1358) x 100 = -26.82%

(ii) ROE (Normal Condition) = 0.1358 , ROE (Expansion) = 0.1504

Therefore, % change in ROE = ( 0.1504 - 0.1358 / .1358) x 100 = 10.75%

Economic Condition EBIT/Net Profit % Change New EBIT/Net Profit Normal 28000 $ 0 28000$ Expansion 28000 $ +10% 30800$ Recession 28000$ -25% 21000$

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