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Question - RAK, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $135,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0. Assume the firm has a tax rate of 35 percent.
Required -
1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.
2. Calculate the percentage changes in ROE when the economy expands or enters a recession.
3. Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.
4. Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession.
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