Question

Castle, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. The firm is considering a debt issue of $60,000 with an interest rate of 7 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 stock price remains constant.
Assume the firm has a tax rate of 35 percent.

c-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 %

c-2. Calculate the percentage changes in ROE when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)


% change in ROE
Recession %
Expansion %

c-3. 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.)


ROE
Recession %
Normal %
Expansion %

c-4. Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession.(A negative answer 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 in ROE
Recession %
Expansion %

Answer 1

Answer:

c-1. ROE under Recession = 8.34%; ROE under Normal = 10.82%; and ROE under Expansion = 12.71%.

c-2. % change in ROE under Recession = -22.91%; and % change in ROE under Expansion = 17.46%.

c-3. ROE under Recession = 10.82%; ROE under Normal = 14.67%; and ROE under Expansion = 17.51%.

c-4. % change in ROE under Recession = -26.23%; and % change in ROE under Expansion = 19.41%

Explanation:

c-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.)

Note: See part 1 of the attached excel file for the calculations of Net Income, Shareholders' Equity, and return on equity (ROE) under each of the three economic scenarios before any debt is issued.

In the attached excel file, return on equity (ROE) is calculated using the following formula:

ROE = (Net income / Shareholders' Equity) * 100

After applying the ROE formula, the following are then obtained:

ROE under Recession = 8.34%

ROE under Normal = 10.82%

ROE under Expansion = 12.71%

c-2. Calculate the percentage changes in ROE when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

Note: See part 1 of the attached excel file for the calculations of the percentage changes in ROE when the economy expands or enters a recession.

In the attached excel file, percentage changes in ROE is calculated as follows:

Percentage change in ROE = (ROE under recession/expansion - ROE under Normal) / ROE under Normal

After applying the Percentage change in ROE formula, the following are then obtained:

% change in ROE under Recession = -22.91%

% change in ROE under Expansion = 17.46%

c-3. 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.)

Note: See part 2 of the attached excel file for the calculations of Net Income, Shareholders' Equity, and return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.

In the attached excel file, return on equity (ROE) is calculated using the following formula:

ROE = (Net income / Shareholders' Equity) * 100

After applying the ROE formula, the following are then obtained:

ROE under Recession = 10.82%

ROE under Normal = 14.67%

ROE under Expansion = 17.51%

c-4. Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession.(A negative answer 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.)

Note: See part 2 of the attached excel file for the calculations of the percentage changes in ROE when the economy expands or enters a recession.

In the attached excel file, percentage changes in ROE is calculated as follows:

Percentage change in ROE = (ROE under recession/expansion - ROE under Normal) / ROE under Normal

After applying the Percentage change in ROE formula, the following are then obtained:

% change in ROE under Recession = -26.23%

% change in ROE under Expansion = 19.41%

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