Question

Ghost, Inc., has no debt outstanding and a total market value of $395,600. Earnings before interest and taxes, EBIT, are projected to be $53,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 13 percent higher. If there is a recession, then EBIT will be 22 percent lower. The company is considering a $195,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,600 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0 and the stock price remains constant.
a-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

a-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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
b-1. Assume the firm goes through with the proposed recapitalization. Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
b-2.
Assume the firm goes through with the proposed 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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Assume the firm has a tax rate of 21 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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Answer:

a-1          expands normal worse

EBIT  59890 53000 41340

equity  395600 395600 395600

   

ROE  15.14% 13.40% 10.45%

a-2                  

% change       1.74%                           -2.95%

b-1 EBIT  59890 53000 41340

equity  200600 200600 200600

debt  195000 195000 195000

ROE  29.86% 26.42% 20.61%

b-2

% change      3.44%                         -5.81%

c-1 EBIT  59890 53000 41340

tax (21%)  12576.90   11130 8681.40

NPAT  47313.10 41870 32658.60

equity  395600 395600 395600

   

ROE  11.96% 10.58%     8.26%

c-2

% change       1.38%                           -2.32%

c-3 EBIT  59890 53000 41340

tax (21%)  12576.90   11130 8681.40

NPAT  47313.10 41870.00  32658.60

equity  200600 200600 200600

debt  195000 195000 195000

   

ROE  23.59% 20.87% 16.28%

c-4

% change       2.72%                        -4.59%

Explanation:

Market to book ratio = market value per share / book value per share

1.0 = (395600/8600)/ book value per share

book value per share = 46/1.0

                                    =46

equity = shares * book value per share

          = 8600*45

          = $395600

ROE = profit at the end / equity