Charny, Inc., has no debt outstanding and a total market value of $250,000. Earn

Question

Charny, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $42,000 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 30 percent lower. Charny is considering a $100,000 debt issue with an interest rate of 8 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) Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places; e.g., 32.16)
b) Calculate the percentage changes in ROE when the economy expands or enters a recession. (Do not round your intermediate calculations. Negative answers should be indicated by a minus sign.)

A.a) Recession 16.76%, Normal 19.8%, Expansion 29.82%
b) Recession -50%, Expansion +27.98% B.a) Recession 11.76%, Normal 16.8%, Expansion 19.82%
b) Recession -30%, Expansion +17.98% C.a) Recession 11.76%, Normal 16.8%, Expansion 19.82%
b) Recession -5.04%, Expansion +3.02% D.a) Recession 11.76%, Normal 16.8%, Expansion 19.82%
b) Recession -30%, Expansion +68.53%

Explanation / Answer

Answer:

Under normal condition

ROE = 42000/250000

= 16.8%

Under expansionary condition

ROE = (42000*1.18)/250000

= 19.82%

Under recession

ROE = (42000*.70)/250000

= 11.76%

b. Percentage change:

Recession = (11.6-16.8)/16.8 = -30%

Expansion = (19.82-16.8)/16.8 = 17.97

Thus, option B is correct

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