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    Practice Question

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    Pendergast, 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. Pendergast 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.

    a-1
    Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16))

    ROE
    Recession %
    Normal %
    Expansion %

    a-2
    Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign.)

    % change in ROE
    Recession %
    Expansion %

    Assume the firm goes through with the proposed recapitalization.

    b-1
    Calculate the return on equity (ROE) under each of the three economic scenarios. (Round your answers to 2 decimal places. (e.g., 32.16))

    ROE
    Recession %
    Normal %
    Expansion %

    b-2
    Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))

    % change in ROE
    Recession %
    Expansion %

    Assume the firm has a tax rate of 35 percent.

    c-1
    Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16))

    ROE
    Recession %
    Normal %
    Expansion %

    c-2
    Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign.)

    % change in ROE
    Recession %
    Expansion %

    c-3
    Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Round your answers to 2 decimal places. (e.g., 32.16))

    ROE
    Recession %
    Normal %
    Expansion %

    c-4
    Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))

    % change in ROE
    Recession %
    Expansion %

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    https://brainmass.com/business/finance/roe-economic-scenarios-552423

    Solution Summary

    The expert computes the rate on equity (ROE) under three different economic scenarios. The percentage of ROE is also calculated.

    $2.19