NARRBEGIN: Kennesaw Steel Corp.
Kennesaw Steel Corporation
As Chief Financial Officer of the Kennesaw Steel Corporation (KSC),you are considering a recapitalization plan that would convert KSC from its current all-equity capital structure to one including substantial financial leverage.KSC now has 100,000 shares of common stock outstanding,which are selling for $50.00 each,and the recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of common stock.
-Refer to Kennesaw Steel Corporation.The tax rate is 40%.What is the return on equity under the new plan if EBIT is $600,000 in the next year? (assume that the stock can be repurchased at $50 per share)

Question

Quizplus · Accepted Answer

Before re-capitalization:
Equity = $50 * 100,000 = $5,000,000 (# of shares = 100,000)
After:
Equity = $5,000,000 - $2,000,000 = $3,000,000
Debt = $2,000,000; Interest Paid = $2,000,000*.08 = $160,000
# of shares = $3,000,000 / $50 = 60,000
NI: ($600,000 - $160,000)*(1-.40)= $264,000
Shareholder equity = 60,000 * $50 = $3,000,000
ROE = 8.8%