Kaelea Inc has no debt outstanding and a total market value

Kaelea, Inc., has no debt outstanding and a total market value of $125,000. Earnings before interest and taxes, EBIT, are projected to be $10,400 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 35 percent lower. Kaelea is considering a $42,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,250 shares outstanding. Assume Kaelea 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, assuming no taxes. (Do not round intermediate calculations. Enter your answers as a percentage rounded to 2 decimal places (e.g., 32.16).)

Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answers as a percentage rounded to 2 decimal places (e.g., 32.16).)

Requirement 2:

Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).)

Calculate the percentage changes in ROE for economic expansion and recession. (Do not roundintermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answers as a percentage rounded to 2 decimal places (e.g., 32.16).)

Requirement 3:

Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in ROE for economic expansion and recession. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.Enter your answers as a percentage rounded to 2 decimal places (e.g., 32.16).)

Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming the firm goes through with the proposed recapitalization. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answers as a percentage rounded to 2 decimal places (e.g., 32.16).)

Kaelea, Inc., has no debt outstanding and a total market value of $125,000. Earnings before interest and taxes, EBIT, are projected to be $10,400 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 35 percent lower. Kaelea is considering a $42,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,250 shares outstanding. Assume Kaelea has a market-to-book ratio of 1.0.

Solution

Requirement 1: a) Value of debt 0 0 0 Value of equity 125000 125000 125000 Total 125000 125000 125000 Number of shares 6250 6250 6250 Normal Strong Expansion Recession EBIT 10400 12480 6760 Interest 0 0 0 EBT 10400 12480 6760 Tax = 0 0 0 0 NI 10400 12480 6760 ROE = (NI/Value of equity) 8.32% 9.98% 5.41% b) % Change in ROE 20.00% -35.00% Requirement 2: a) Value of debt 42000 42000 42000 Value of equity 83000 83000 83000 Total 125000 125000 125000 Number of shares (6250*83000/125000) 4150 4150 4150 Normal Strong Expansion Recession EBIT 10400 12480 6760 Interest = 42000*6% = 2520 2520 2520 EBT 7880 9960 4240 Tax= 0 0 0 0 NI 7880 9960 4240 ROE = (NI/Value of equity) 9.49% 12.00% 5.11% b) % Change in ROE 26.40% -46.19% Requirement 3: a) Value of debt 0 0 0 Value of equity 125000 125000 125000 Total 125000 125000 125000 Number of shares 6250 6250 6250 Normal Strong Expansion Recession EBIT 10400 12480 6760 Interest 0 0 0 EBT 10400 12480 6760 Tax at 35% 3640 4368 2366 NI 6760 8112 4394 ROE = (NI/Value of equity) 5.41% 6.49% 3.52% % Change in ROE 20.00% -35.00% b) Value of debt 42000 42000 42000 Value of equity 83000 83000 83000 Total 125000 125000 125000 Number of shares (6250*83000/125000) 4150 4150 4150 Normal Strong Expansion Recession EBIT 10400 12480 6760 Interest = 42000*6% = 2520 2520 2520 EBT 7880 9960 4240 Tax at 35% 2758 3486 1484 NI 5122 6474 2756 ROE = (NI/Value of equity) 6.17% 7.80% 3.32% % Change in ROE 26.40% -46.19%