CH 13 Q3 Part 1 Kaelea, Inc., has no debt outstanding and a total market value o

Question

CH 13 Q3 Part 1

Kaelea, Inc., has no debt outstanding and a total market value of $106,000. Earnings before interest and taxes, EBIT, are projected to be $9,700 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 22 percent higher. If there is a recession, then EBIT will be 33 percent lower. Kaelea is considering a $30,600 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,300 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.) Assume the firm goes through with the proposed recapitalization and no taxes. 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).)

Explanation / Answer

  1-a.     Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE:

                        ROE = NI/$106,000

                        The ROE for each state of the economy under the current capital structure and no taxes is:                    

Recession      Normal          Expansion

                        Profit                     6499           9700                11834

                      ROE 6.13          9.15                 11.16

               1-b. Percentage change in ROE :

                                     Recession     Normal          Expansion

ROE                                   6.13          9.15                 11.16

% change in ROE 33.00           -                      22.00

           2-a If the company undertakes the proposed recapitalization, the new equity value will be:

         Equity = $106,000 – 30,600

         Equity = $75,400   

So, the ROE for each state of the economy is:

         ROE = NI/$75,400

There will be extra intrest cost = 30600*.07 = 2142

New normal profit = 9700-2142 = 7558

Recession    Normal       Expansion

                        Profit                         5063         7558           9220

ROE 6.71          10.02              12.23

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