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Practice Question

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 %

Solution Summary

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

$2.19