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ROE and Leverage Suppose the company in Problem 1 has a market-to-book ratio of 1.0.
a. 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.
b. Repeat part (a) assuming the firm goes through with the proposed recapitalization.
c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35 percent.
Problem 1
EBIT and Leverage Beckett, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $13,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 35 percent higher. If there is a recession, then EBIT will be 40 percent lower. Beckett is considering an $80,000 debt issue with a 6 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 4,000 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Beckett goes through with recapitalization. What do you observe?
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