Ghost, Inc., has no debt outstanding and a total market value of $450,000. Earnings before interest and taxes, EBIT, are projected to be $57,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 16 percent higher. If there is a recession, then EBIT will be 24 percent lower. The company is considering a $215,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 9,000 shares outstanding. The company has a tax rate of 25 percent, a market-to-book ratio of 1.0, and the stock price remains constant. Required:
a. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.
b. Calculate the percentage changes in ROE when the economy expands or enters a recession.
c. Assume the firm goes through with the proposed recapitalization. Calculate the return on equity (ROE) under each of the three economic scenarios.
d. Assume the firm goes through with the proposed recapitalization. Calculate the percentage changes in ROE when the economy expands or enters a recession.