Music City, Inc., has no debt outstanding and a total market value of $150,000.

Question

Music City, Inc., has no debt outstanding and a total market value of $150,000. 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 20 percent higher. If there is a recession, then EBIT will be 25 percent lower. The company is considering a $60,000 debt issue with an interest rate of 7 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.

a-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE: Recession % =? Normal %=? Expansion %=?

a-2. 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.) % change in ROE Recession =?% Expansion=?%

Assume the firm goes through with the proposed recapitalization.

b-1. Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE: Recession=?% Normal=?% Expansion=?%

b-2. 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.) % change in ROE: Recession=?% Expansion=?%

Assume the firm has a tax rate of 35 percent.

c-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and 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 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.) % change in ROE: Recession=?% Normal=?% 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 and 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. (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.) % change in ROE: Recession=?% Expansion=?%

Explanation / Answer

a-1) BEFORE RECAPITALIZATION AND WITHOUT TAX: Debt 0 Equity 150000 Total capital 150000 Recession Normal Expansion EBIT 21000 28000 33600 Interest 0 0 0 EBT 21000 28000 33600 Tax 0 0 0 NI 21000 28000 33600 ROE = NI/Equity 14.00% 18.67% 22.40% a-2) % Change in ROE -25% 20% WITH RECAPITALIZATION AND NOT TAXES: b-1) Debt 60000 Equity 90000 Total capital 150000 Recession Normal Expansion EBIT 21000 28000 33600 Interest AT 7% 4200 4200 4200 EBT 16800 23800 29400 Tax 0 0 0 NI 16800 23800 29400 ROE = NI/Equity 18.67% 26.44% 32.67% b-2) % Change in ROE -29.41% 23.53% c-1) BEFORE RECAPITALIZATION AND WITH TAXES: Debt 0 Equity 150000 Total capital 150000 Recession Normal Expansion EBIT 21000 28000 33600 Interest 0 0 0 EBT 21000 28000 33600 Tax at 35% 7350 9800 11760 NI 13650 18200 21840 ROE = NI/Equity 9.10% 12.13% 14.56% c-2) % Change in ROE -25% 20% WITH RECAPITALIZATION AND NO TAXES: c-3) Debt 60000 Equity 90000 Total capital 150000 Recession Normal Expansion EBIT 21000 28000 33600 Interest at 7% 4200 4200 4200 EBT 16800 23800 29400 Tax at 35% 5880 8330 10290 NI 10920 15470 19110 ROE = NI/Equity 12.13% 17.19% 21.23% c-4) % Change in ROE -29.41% 23.53%

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