Question

has projected EBIT to be $225,000 for next year. Their tax rate is 21% and there is $`500,000 in equity. Precise Electronics Inc has no debt currently, but the board is considering a loan of $150,000 at 8% interest, which they will use to repurchase shares of their own stock at $50 per share. If there is a recession, EBIT could be only 75% of projected. If there is an expansion, EBIT might be 40% greater than projected. What will their return on equity be under the current structure and under the proposed structure for each scenario

Answer 1

current EBIT = $225,000, net income = $225,000 x 0.79 = $177,750

EBIT under expansion = $225,000 x 1.4 = $315,000, net income = $315,000 x 0.79 = $248,850

EBIT under recession = $225,000 x 0.75 = $168,750, net income = $168,750 x 0.79 = $133,312.50

current equity = $500,000

equity under proposed structure = $500,000 - $150,000 = $350,000

interest expense per year under proposed structure = $150,000 x 8% = $12,000

net income current economy = ($225,000 - $12,000) x 0.79 = $168,270

net income economic expansion = ($315,000 - $12,000) x 0.79 = $239,370

net income economic recession = ($168,750 - $12,000) x 0.79 = $123,832.50

return on equity = net income / total equity

ROE under current structure:

• no change in the economy = $177,750 / $500,000 = 35.55%
• economic expansion = $248,850 / $500,000 = 49.77%
• economic recession = $133,312.50 / $500,000 = 26.67%

ROE under proposed structure:

• no change in the economy = $168,270 / $350,000 = 48.08%
• economic expansion = $239,370 / $350,000 = 68.39%
• economic recession = $123,832.50 / $350,000 = 35.38%