Pendergast, Inc., has no debt outstanding and a total market value of $180,000. Earnings before...

Question:

Pendergast, Inc., has no debt outstanding and a total market value of $180,000. 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 20 percent higher. If there is a recession, then EBIT will be 30 percent lower. Pendergast is considering a $75,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 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.

a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.

b-1 Calculate the return on equity (ROE) under each of the three economic scenarios.

b-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.

c-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.

c-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.

c-3 Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.

c-4 Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession.

Capital Structure Decision

A lot of analyses are done to take a decision on the optimal capital structure ( debt equity mix). One of the analyses is to assess the impact of alternative capital structures on the return on equity (ROE).

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Answer a 1 & Answer c1

  • Since the firm has a market to book ratio of 1, the market value of equity = book value of equity
  • ROE = net income / Book...

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Capital Structure & the Cost of Capital

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Chapter 15 / Lesson 1
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In this lesson, we'll define capital and a firm's capital structure. We'll also discuss the costs associated with each component in the capital structure and learn about the concept of risk and return.


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