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

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. Leverage Ratio (Debt/Total Assets 0% 25% 50% Total assets $10,000,000 $7,500,000 $5,000,000 Debt (at 12% interest) $0 2,500,000 5,000,000 Equity 10,000,000 10,000,000 10,000,000 Total liabilities & equity 10,000,000 12,500,000 15,000,000 Expected operating income (EBIT) 2,500,000 2,500,000 2,500,000 Less: Interest (at 12%) $0 300,000 600,000 Earnings before tax 2,500,000 2,200,000 1,900,000 Less: Income tax at 40% 1,000,000 880,000 760,000 Earnings after tax 1,500,000 1,320,000 1,140,000 Return on equity 15.00% 13.20% 11.40% Effect of a 20% Decrease in EBIT to $2,000,000 Expected operating income (EBIT) $2,000,000 $2,000,000 $2,000,000 Less:Interest (at 12%) $0 300,000 600,000 Earings before tax 2,000,000 1,700,000 1,400,000 Less: Income tax at 40% 800,000 680,000 560,000 Earings after tax 1,200,000 1,020,000 840,000 Return on equity 12.00% 10.20% 8.40% Effect of a 20% Increase in EBIT to $3,000,000 Expected operating income (EBIT) $3,000,000 $3,000,000 $3,000,000 Less: Interest (at 12%) 2,000,000 1,700,000 1,400,000 Earnings before tax 1,000,000 1,300,000 1,600,000 Less: Income tax at 40% 400,000 520,000 640,000 Earings after tax 600,000 780,000 960,000 Return on equity 6.00% 7.80% 9.60% 1) 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% 2) Which leverage ratio yields the highest expected return on equity? 3) Which leverage ration yields the highest variablility (risk) in expected return on equity? 4) 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

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 ration (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 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 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?

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