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a)
To calculate: The
Introduction:
The ROE (Return on equity) is the profitability measure that computes the amount of dollar a firm creates with every dollar of shareholders equity.
a)
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Explanation of Solution
Given information:
Company R has no outstanding debt and its market value is $165,000. The EBIT (Earnings before Interest and Taxes) are expected to be $21,000 at normal economic conditions. If the economy condition is strong, then the EBIT will increase to 25% and if the economy enters into a recession, then it will decrease to 35%. The company has market-to-book value ratio of 1.0%.
Formula to calculate the ROE:
Compute ROE:
Hence, the ROE during recession period is 0.0827.
Hence, the ROE during normal period is 0.1273.
Hence, the ROE during expansion period is 0.1591.
Formula to calculate the percentage change in ROE:
Compute the percentage change in ROE for recession period:
Hence, the percentage change in ROE for recession period is -$35.
Compute the percentage change in ROE for expansion period:
Hence, the percentage change is ROE for expansion period is +25.
Table showing the ROE for the three possible periods of economy under the present capital structure with no taxes:
Recession | Normal | Expansion | |
ROE | 0.0827 | 0.1273 | 0.1591 |
%ΔROE | –35 | 0 | 25 |
b)
To calculate: The return on equity for the three economic scenarios before any issue of debt. Also, compute the percentage changes in return on equity, assuming that the company goes through a proposed recapitalization.
Introduction:
The ROE (Return on equity) is the profitability measure that computes the amount of dollar a firm creates with every dollar of shareholders equity.
b)
![Check Mark](/static/check-mark.png)
Explanation of Solution
Given information:
The company is considering the debt issue of $60,000 with the rate of interest @7%. At present, the outstanding shares of $5,500 exist.
Formula to calculate the share price:
Compute the share price:
Hence, the price of the share is $30.
Formula to calculate the repurchased shares:
Compute the repurchased shares:
Hence, the repurchased shares are $2,000.
Formula to calculate the payment of interest:
Compute the payment of interest:
Hence, the payment of interest is $4,200.
Table showing the income statement for the three possible periods of economy under the planned recapitalization:
Recession | Normal | Expansion | |
EBIT | $13,650 | $21,000 | $26,250 |
Interest | 4,200 | 4,200 | 4,200 |
NI | $9,450 | $16,800 | $22,050 |
Note:
- The net income is computed by subtracting the interest from the EBIT.
Formula to calculate equity:
Compute the equity:
Hence, the equity is $105,000.
Formula to calculate the ROE:
Compute ROE:
Hence, the ROE during recession period is 0.09.
Hence, the ROE during normal period is 0.16.
Hence, the ROE during expansion period is 0.21.
Formula to calculate the percentage change in ROE:
Compute the percentage change in ROE for recession period:
Hence, the percentage change in ROE for recession period is -$43.75.
Compute the percentage change in ROE for expansion period:
Hence, the percentage change in ROE for expansion period is +31.25.
Table showing the ROE and the percentage changes in ROE for the three possible periods of economy under the present capital structure with no taxes:
Recession | Normal | Expansion | |
ROE | 0.09 | 0.16 | 0.21 |
%ΔROE | –43.75 | 0 | 31.25 |
c)
To calculate: The return on equity for the three economic scenarios before any issue of debt and to compute the percentage changes in return on equity with the rate of tax at 35%.
Introduction:
The ROE (Return on equity) is the profitability measure that computes the amount of dollar a firm creates with every dollar of shareholders equity.
c)
![Check Mark](/static/check-mark.png)
Explanation of Solution
If a firm maintains its present capital structure with the corporate taxes, then the ROE is as follows:
Formula to calculate taxes:
Compute taxes for three periods:
Hence, the tax during recession is $4,778.
Hence, the tax during normal period is $7,350.
Hence, the tax during expansion is $9,188.
Formula to calculate the NI (Net Income):
Compute NI for three periods:
Hence, the net income during recession is $8,872.
Hence, the net income during normal period is $13,650.
Hence, the net income during expansion period is $17,063
Table showing the income statement for the three possible periods of economy with the EPS and percentage change in EPS:
Recession | Normal | Expansion | |
EBIT | $13,650 | $21,000 | $26,250 |
Interest | 0 | 0 | 0 |
Taxes | 4,778 | 7,350 | 9,188 |
NI | $ 8,873 | $13,650 | $17,063 |
Note:
- The net income is computed by subtracting the interest and taxes from the EBIT.
Formula to calculate the ROE:
Compute ROE:
Hence, the ROE during recession period is 0.0538.
Hence, the ROE during recession period is 0.827.
Hence, the ROE during expansion period is 0.1034.
Formula to calculate the percentage change in ROE:
Compute the percentage change in ROE for recession period:
Hence, the percentage change in ROE for recession period is -$35.
Compute the percentage change in ROE for expansion period:
Hence, the percentage change is ROE for expansion period is +25.
Table showing the ROE and the percentage changes in ROE for the three possible periods of economy under the present capital structure with corporate taxes:
Recession | Normal | Expansion | |
ROE | 0.0538 | 0.0827 | 0.1034 |
%ΔROE | –35 | 0 | 25 |
If a firm undertakes the planned recapitalization with the corporate taxes, then the ROE is as follows:
Formula to calculate the payment of interest:
Compute the payment of interest:
Hence, the payment of interest is $4,200.
Formula to calculate taxes:
Compute taxes for the three periods:
Hence, the tax during recession is $3,307.5.
Hence, the tax during normal period is $5,880.
Hence, the tax during expansion period is $7,718.
Formula to calculate the NI (Net Income):
Compute NI for three periods:
Hence, the net income during recession is $6,143.
Hence, the net income during normal period is $10,920.
Hence, the net income during expansion period is $14,333.
Table showing the income statement for the three possible periods of economy under the planned recapitalization:
Recession | Normal | Expansion | |
EBIT | $13,650 | $21,000 | $26,250 |
Interest | 4,200 | 4,200 | 4,200 |
Taxes | 3,308 | 5,880 | 7,718 |
NI | $6,143 | $10,920 | $14,333 |
Formula to calculate the ROE:
Compute ROE:
Hence, the ROE during recession period is 0.0585.
Hence, the ROE during normal period is 0.1040.
Hence, the ROE during expansion period is 0.1365.
Formula to calculate the percentage change in ROE:
Compute the percentage change in ROE for recession period:
Hence, the percentage change in ROE for recession period is -$43.75.
Compute the percentage change in ROE for expansion period:
Hence, the percentage change is ROE for expansion period is +31.25.
Table showing the ROE and the percentage changes in ROE for the three possible periods of economy under the present capital structure with corporate taxes:
Recession | Normal | Expansion | |
ROE | 0.0585 | 0.104 | 0.1365 |
%ΔROE | –43.75 | 0 | +31.25 |
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Chapter 16 Solutions
Fundamentals of Corporate Finance
- A company had WACC (weighted average cost of capital) equal to 8. % If the company pays off mortgage bonds with an interest rate of 4% and issues an equal amount of new stock considered to be relatively risky by the market, which of the following is true? a. residual income will increase. b. ROI will decrease. c. WACC will increase. d. WACC will decrease.arrow_forwardWhat happens to ROE for Firm U and Firm L if EBIT falls to $1,600? What happens if EBIT falls to $1,200? What is the after-tax cost of debt? What does this imply about the impact of leverage on risk and return?arrow_forwardYou have the following initial information on which to base your calculations and discussion: Debt yield = 2.5% Required Rate of Return on Equity = 13% Expected return on S&P500 = 8% Risk-free rate (rF) = 1.5% Inflation = 2.5% Corporate tax rate (TC) = 30% Current long-term and target debt-equity ratio (D:E) = 1:3 a. What is the unlevered cost of equity (rE*) for this firm? Assume that the management of the firm is considering a leveraged buyout of the above company. They believe that they can gear the company to a higher level due to their ability to extract efficiencies from the firm’s operations. Thus, they wish to use a target debt-equity ratio of 3:1 in their valuation calculations. b. What would the levered cost of equity equal for this firm at a debt-equity ratio (D:E) of 3:1? c. What would the required rate of return for the company equal if it were to be acquired under the leveraged buyout structure (i.e., what would the estimated firm WACC equal to under a…arrow_forward
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- Cornerstones of Cost Management (Cornerstones Ser...AccountingISBN:9781305970663Author:Don R. Hansen, Maryanne M. MowenPublisher:Cengage Learning
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