Music City, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 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 30 percent lower. The company is considering a $75,000 debt issue 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 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.
Recession?
Normal?
Expansion?
a-2. Calculate the percentage changes in ROE when the economy expands or enters a recession.
Recession?
Expansion?
Assume the firm goes through with proposed recapitalization.
b-1. Calculate return on equity (ROE) under each of the three economic scenarios
Recession?
Normal?
Expansion?
b-2. Calculate the percentage changes in ROE when the economy expands or enters a recession.
Recession?
Expansion?