CH 13 drill Q 3 Part 2 Kaelea, Inc., has no debt outstanding and a total market
ID: 2718202 • Letter: C
Question
CH 13 drill Q 3 Part 2
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.
Explanation / Answer
b. Percentage change of ROE in expansion and recession:
EBIT = 9,700
EBIT in case of expansion = 9,700 x 1.22 = $11,834
EBIT in case of recession = 9,700 x 0.67 = $6,499
ROE = EBIT / Market Value of Equity.
ROE in case of Expansion = 11,834 / 106,000 = 11.164150943%
ROE in case of Recession = 6,499/ 106,000 = 6.131132075%
Current ROE = 9,700 / 106,000 = 9.150943396%
% Change in Expansion = 11.164150943 - 9.150943396 / 9.150943396 = 22%
% Change in Recession = 9.150943396 - 6.131132075 / 9.150943396 = 33%