- Money, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $14,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 60 percent lower. Money is considering a $60,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. The company has a market-to-book ratio of 1.0. Ignore taxes for parts a and b.
- 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, assuming no taxes.
- Repeat part (a) assuming the firm goes through with the proposed recapitalization.
- Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35 percent.
- Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE:
ROE = NI/$150,000
The ROE for each state of the economy under the current capital structure and no taxes is:
| Recession | Normal | Expansion | |||
| ROE | .0373 | .0933 | .1213 | ||
| %DROE | –60 | ––– | +30 |
The second row shows the percentage change in ROE from the normal economy.
- If the company undertakes the proposed recapitalization, the new equity value will be:
Equity = $150,000 – 60,000
Equity = $90,000
So, the ROE for each state of the economy is:
ROE = NI/$90,000
| Recession | Normal | Expansion | |||
| ROE | .0222 | .1156 | .1622 | ||
| %DROE | –76.36 | ––– | +38.18 |
- If there are corporate taxes and the company maintains its current capital structure, the ROE is:
| ROE | .0243 | .0607 | .0789 | ||
| %DROE | –60 | ––– | +30 |
If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE for each state of the economy is:
| ROE | .0144 | .0751 | .1054 | ||
| %DROE | –76.36 | ––– | +38.18 |
Notice that the percentage change in ROE is the same as the percentage change in EPS. The percentage change in ROE is also the same with or without taxes.
