Castle, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 12 percent higher. If there is a recession, then EBIT will be 20 percent lower. The firm is considering a debt issue of $90,000 with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for questions a and b. Assume the stock price remains constant.
a-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.(Recession, Expansion, Normal)
a-2. Calculate the percentage changes in ROE when the economy expands or enters a recession.
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.
c-4. Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession.