RAK, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $105,000 debt issue with an interest rate of 4 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.
a1- Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.
a2- Calculate the percentage changes in ROE when the economy expands or enters a recession.
Assume the firm goes through with the proposed recapitalization.
b1- Calculate the return on equity (ROE) under each of the three economic scenarios.
b2- Calculate the percentage changes in ROE when the economy expands or enters a recession.
Assume the firm has a tax rate of 35 percent.
c1- Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.
c2- Calculate the percentage changes in ROE when the economy expands or enters a recession.
c3- Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.
c4- Given the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.