Kaelea, Inc., has no debt outstanding and a total market value of $110,000. Earnings before interest and taxes, EBIT, are projected to be $8,800 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 23 percent higher. If there is a recession, then EBIT will be 32 percent lower. The company is considering a $36,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,400 shares outstanding. Assume the company has a market-to-book ratio of 1.0.
Assume the firm goes through with the proposed recapitalization and no taxes.
a) What is the return on equity, ROE, under each of the three economic scenarios after the recapitalization
Assume the firm has a tax rate of 35 percent
b) What is the return on equity, ROE, under each of the three economic scenarios before any debt is issued
c) What is the return on equity, ROE, under each of the three economic scenarios after the recapitalization