Music City, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 30 percent lower. The company is considering a $75,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is 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. Assume the firm goes through with proposed recapitalization.
c. Calculate return on equity (ROE) under each of the three economic scenarios.
d. Calculate the percentage changes in ROE when the economy expands or enters a recession.