RAK Inc has no debt outstanding and a total market value of

RAK, Inc, has no debt outstanding and a total market value of $240,000 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 15 percent higher. If there is a recession, then EBIT will be 30 percent lower. RAK is considering a $80,000 debt issue with an interest rate of 7 percent The proceeds will be used to repurchase shares of stock There are currently 15,000 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. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession Normal Expansion 933 | % 13.33 % 15331% a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) %change inROE 30.01 | % 15 % 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. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g 32.16.) ROE Recession Normal Expansion

Solution

Formula sheet

A	B	C	D	E	F	G	H
2
3		Total Market Value before debt Issue	$240,000
4		Number of shares outstanding	15000
5		Debt Issue	$80,000
6		Interest rate	7%
7		Market to Book Ratio	1
8
9			Recession	Normal	Expansion
10		EBIT	$22,400	$32,000	$36,800
11
12		b-1)
13		Price Per Share before issue of debt	$16
14		Number of shares bought using debt	5000
15
16		Number of stocks Outstanding after the issue of debt	10000
17
18			Recession	Normal	Expansion
19		EBIT	$22,400	$32,000	$36,800
20		Interest Expense	$5,600	$5,600	$5,600
21		Income before Tax	$16,800	$26,400	$31,200
22		Tax	0	0	0
23		Income after tax or net income	$16,800	$26,400	$31,200
24		Shareholders Equity (Book Value)	$160,000	$160,000	$160,000
25		ROE	10.50%	16.50%	19.50%
26
27			ROE
28		Recession	10.50%
29		Normal	16.50%
30		Expansion	19.50%
31
32		b-2)
33
34		Recession	-36.36%
35		Expansion	18.18%
36
37		c-1)
38
39			Recession	Normal	Expansion
40		EBIT	$22,400	$32,000	$36,800
41		Interest Expense	$0	$0	$0
42		Income before Tax	$22,400	$32,000	$36,800
43		Tax	$7,840	$11,200	$12,880
44		Income after tax or net income	$14,560	$20,800	$23,920
45		Shareholders Equity (Book Value)	$240,000	$240,000	$240,000
46		ROE	6.07%	8.67%	9.97%
47
48			ROE
49		Recession	6.07%
50		Normal	8.67%
51		Expansion	9.97%
52
53		c-2)
54
55		Recession	-30.00%
56		Expansion	15.00%
57
58		c-3)
59
60			Recession	Normal	Expansion
61		EBIT	$22,400	$32,000	$36,800
62		Interest Expense	$5,600	$5,600	$5,600
63		Income before Tax	$16,800	$26,400	$31,200
64		Tax	$5,880	$9,240	$10,920
65		Income after tax or net income	$10,920	$17,160	$20,280
66		Shareholders Equity (Book Value)	$160,000	$160,000	$160,000
67		ROE	6.83%	10.73%	12.68%
68
69			ROE
70		Recession	6.83%
71		Normal	10.73%
72		Expansion	12.68%
73
74		c-4)
75
76		Recession	-36.36%
77		Expansion	18.18%
78