RAK Inc. has no debt outstanding and a total market value of $500,000. Earnings before interest and taxes, EBIT, are projected to be $75,000 if economic conditions are normal; if there is a strong economic expansion, then EBIT will be 30% higher; if there is recession, and EBIT will be 40% lower. The company is considering a $200,000 debt issue with an interest rate of 5.5%. Proceeds will be used to repurchase shares of stock there are currently 10,000 shares outstanding. Ignore taxes for the first part of this problem. Assume the company has a market the book ratio of 1:1.
Suppose the company has a market-to-book ratio of 1.0.
Part A) Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes.
Part B) Repeat A) assuming the firm goes through with the proposed recapitalization.
Part C) Repeat A and B above assuming the firm has a tax rate of 35 percent.