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

RAK, Inc., has no debt outstanding and a total market value of $140,000. 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 12 percent higher. If there is a recession, then EBIT will be 30 percent lower. RAK is considering a $115,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.

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.)

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.)

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.)

Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))

ROE = NI/E

a1)

a2). Sensitivity Analysis: Normal to Recession

%?ROE = (.16 - .2286)/.2286 = -.30 or -30%

Sensitivity Analysis: Normal to Expansion

%?ROE = (.256 - .2286)/.2286 = .12 or 12%

b1). If the firm goes forward with recapitalization, the new equity value will be:

Equity = $140,000 - $115,000 = $25,000

Interest = $115,000 x 6% = $6,900

$25,000

b2). Sensitivity Analysis: Normal to Recession

%?ROE = (.62 - 1.004)/1.004 = -.3825 or -38.25%

Sensitivity Analysis: Normal to Expansion

%?ROE = (1.1576 - 1.004)/1.004 = .1530 or 15.30%

c1).

Recession Normal Expansion

EBIT $22,400 $32,000 $35,840

Less:Taxes(@35%) 7,840 11,200 12,544

NI $14,560 $20,800 $23,296

ROE 0.104 0.1486 0.1664

c2). Sensitivity Analysis: Normal to Recession

%?ROE = (.104 - .1486)/.1486 = -.3001 or -30%

Sensitivity Analysis: Normal to Expansion

%?ROE = (.1664 - .1486)/.1486 = .1198 or 12%

c3). Equity = $140,000 - $115,000 = $25,000

Interest = $115,000 x 6% = $6,900

Recession Normal Expansion

EBIT $22,400 $32,000 $35,840

Less: Interest 6,900 6,900 6,900

EBT $15,500 $25,100 $28,940

Less:Taxes(@35%) 5,425 8,785 10,129

NI $10,075 $16,315 $18,811

ROE 0.403 0.6526 0.75244

c4). Sensitivity Analysis: Normal to Recession

%?ROE = (.403 - .6526)/.6526 = -.3825 or -38.25%

Sensitivity Analysis: Normal to Expansion

%?ROE = (.75244 - .6526)/.6526 = .1530 or 15.30%

	Recession(-30%)	Normal	Expansion(+12%)
EBIT=NI	$32,000(1 - 0.3) = $22,400	$32,000	$32,000(1 + 0.12) = $35,840
Equity	$140,000	$140,000	$140,000
ROE	$22,400/$140,000 = 0.16, or 16%	$32,000/$140,000 = 0.2286, or 22.86%	$35,480/$140,000 = 0.256, or 25.6%

RAK, Inc., has no debt outstanding and a total market value of $140,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 if economic condi

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

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