Arrow Technology, Inc. (ATI) has total assets of $10 million and expected operat

Question

Arrow Technology, Inc. (ATI) has total assets of $10 million and expected operating
income (EBIT) of $2.5 million. If ATI uses debt in its capital structure, the cost of
this debt will be 12 percent per annum.
a. Complete the following table:
Leverage Ratio (Debt/Total Assets)
0% 25% 50%
Total assets ______ ______ ______
Debt (at 12% interest) ______ ______ ______
Equity ______ ______ ______
Total liabilities and equity ______ ______ ______
Expected operating income (EBIT) ______ ______ ______
Less: Interest (at 12%) ______ ______ ______
Earnings before tax ______ ______ ______
Less: Income tax at 40% ______ ______ ______
Earnings after tax ______ ______ ______
Return on equity ______ ______ ______
Effect of a 20% Decrease in EBIT to $2,000,000
Expected operating income (EBIT) ______ ______ ______
Less: Interest (at 12%) ______ ______ ______
Earnings before tax ______ ______ ______
Less: Income tax at 40% ______ ______ ______
Earnings after tax ______ ______ ______
Return on equity ______ ______ ______
Effect of a 20% Increase in EBIT to $3,000,000
Expected operating income (EBIT) ______ ______ ______
Less: Interest (at 12%) ______ ______ ______
Earnings before tax ______ ______ ______
Less: Income tax at 40% ______ ______ ______
Earnings after tax ______ ______ ______
Return on equity ______ ______ ______
b. Determine the percentage change in return on equity of a 20 percent decrease
in expected EBIT from a base level of $2.5 million with a debt-to-total-assets
ratio of
i. 0%
ii. 25%
iii. 50%
c. Determine the percentage change in return on equity of a 20 percent increase
in expected EBIT from a base level of $2.5 million with a debt-to-total-assets
ratio of
i. 0%
ii. 25%
iii. 50%
d. Which leverage ratio yields the highest expected return on equity?
e. Which leverage ratio yields the highest variability (risk) in expected return on
equity?
f. What assumption was made about the cost of debt (i.e., interest rate) under
the various capital structures (i.e., leverage ratios)? How realistic is this
assumption?

Explanation / Answer

Refer to the link below, it google doc spreadsheet.

I have only answered part a and b. Break the problem in 3 post.

https://docs.google.com/spreadsheet/ccc?key=0AqFfmpAerqFgdDZkTldDd3V5TTJkNHlIVjQ1TlN4QlE

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