Problem - ROE and Leverage
Money, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 25 percent lower. Money is considering a $48,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 20.000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.
a-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and round your final answers to 2 decimal places.
ROE
Recession
Normal
Expansion
a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.
% change in ROE
Recession
Expansion
Assume the firm goes through with the proposed recapitalization.
b-1. Calculate the return on equity (ROE) under each of the three economic scenarios.
b-2. Calculate the percentage changes in ROE when the economy expands or enters a recession.
Assume the firm has a tax rate of 35 percent.
c-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued
c-2. Calculate the percentage changes in ROE when the economy expands or enters a recession.
c-3. Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.