ROE and Leverage
Money, Inc., has no dept 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% higher. If there is a recession, than EBIT will be 60% lower. Money is considering a $60,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. Ignore taxes for this problem.
Suppose the company 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 trough with the proposed recapitalization.
c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35%.
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.
Since the market to book ratio is 1.0, it implies that the book value = market value. The book value of equity = 150,000
Return on Equity = Net Income/Book Value of equity
Since there are no taxes and no interest, net income = EBIT
Under normal condition ROE = 14,000/150,000 = 9.33%
Under strong expansion ROE = (14,000X1.3)/150,000 = 12.13%
Under recession ROE = (14,000X0.4)/150,000 = 3.73%
Under expansion, the percentage ...
The solution explains how to calculate the ROE and leverage for Money Inc under different economic circumstances
Profit Margin and ROE
A. Describe some of the advantages and disadvantages of ROE as a measure of corporate profitability. What is a typical level of ROE, and how does one know if the ROE reported by a given company reflects an adequate return on investment?
B. Define the profit margin, total asset turnover, and financial leverage factors that contribute to ROE. Discuss the advantages and disadvantages of each of these potential sources of high ROE.
C. Based upon the finding reported in Table 11.3, discuss the relation between P/E ratios and ROE, profit margins, total asset turnover, and financial leverage. In general, which component of ROE is the most useful indicator of the firm's ability to sustain high profit rates in the future?
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