Maynard Inc. has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If there is a strong expansion in the economy, than EBIT will be 30 percent higher. If there is a recession, than EBIT will be 50 percent lower. Maynard is considering a $90,000 debt issue with a 7% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding.
Suppose this company has a market-to-book ratio of 1.0.
A) find out return on equity (ROE) under each of there three economic scenarios before any debt is issued. Also find out 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%