Music City, Inc., has no debt outstanding and a total market value of $295,000. Earnings before interest and taxes, EBIT, are projected to be $23,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percent lower. The company is considering an $88,500 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding.
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 through with the proposed recapitalization.
c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35 percent.