Financial leverage effects The Neal Company wants to estimate next year\'s retur

Question

Financial leverage effects The Neal Company wants to estimate next year's return on equity (ROE) under different leverage ratios. Neal's total capital is $17 million, it currently uses only common equity, it has no future plans to use preferred stock in its capital structure, and its federal-plus-state tax rate is 40%. The CFO has estimated next year's EBIT for three possible states of the world: $4.7 million with a 0.2 probability, $2.6 million with a 0.5 probability, and $700,000 with a 0.3 probability. Calculate Neal's expected ROE, standard deviation and coefficient of variation for each ofthe following debt to capital ratios. Do not round intermediate calculations. Round your answers to two decimal places at the end of the calculations. Debt/Capital ratio is 0. ROE CV= Debt/Capital ratio is 10%, interest rate is 9%. ROE = CV = Debt/Capital ratio is 50%, interest rate is 11%. ROE = CV = Debt/Capital ratio is 60%, interest rate is 14%. ROE = CV=

Explanation / Answer

Debt/Capital Ratio is 0 Debt = 0 Equity 17000000 State Probability EBIT Net Income     (EBIT-Int*debt)(1-tax) ROE (x) = NI/Total Equity Prob(ROE) Prob(X-)^2 1 0.2 4700000 2820000 0.166 0.033 0.001276 2 0.5 2600000 1560000 0.092 0.046 0.000017 3 0.3 700000 420000 0.025 0.007 0.001127 = 0.086 0.002420 RE = 8.60% = 0.002420 4.92% CV = /RE 0.5720 Debt/Capital Ratio is 10% and Interest Rate 9% Debt % = 10% Equity% = 90% Total Capital = 17000000 Debt = 1700000 Equity = 15300000 Interest Rate = 9% State Probability EBIT Net Income     (EBIT-Int*debt)(1-tax) ROE (x) = NI/Total Equity Prob(ROE) Prob(X-)^2 1 0.2 4700000 2728200 0.178 0.036 0.001557 2 0.5 2600000 1468200 0.096 0.048 0.000017 3 0.3 700000 328200 0.021 0.006 0.001413 = 0.090 0.002987 RE = 9.01% = 0.002987 5.47% CV = /RE 0.6068 Debt/Capital Ratio is 50% and Interest Rate 11% Debt % = 50% Equity% = 50% Total Capital = 17000000 Debt = 8500000 Equity = 8500000 Interest Rate = 11% State Probability EBIT Net Income     (EBIT-Int*debt)(1-tax) ROE (x) = NI/Total Equity Prob(ROE) Prob(X-)^2 1 0.2 4700000 2259000 0.266 0.053 0.005045 2 0.5 2600000 999000 0.118 0.059 0.000056 3 0.3 700000 -141000 -0.017 -0.005 0.004578 = 0.107 0.009679 RE = 10.69% = 0.009679 9.84% CV = /RE 0.9200 Debt/Capital Ratio is 60% and Interest Rate 14% Debt % = 60% Equity% = 40% Total Capital = 17000000 Debt = 10200000 Equity = 6800000 Interest Rate = 14% State Probability EBIT Net Income     (EBIT-Int*debt)(1-tax) ROE (x) = NI/Total Equity Prob(ROE) Prob(X-)^2 1 0.2 4700000 1963200 0.289 0.058 0.007883 2 0.5 2600000 703200 0.103 0.052 0.000088 3 0.3 700000 -436800 -0.064 -0.019 0.007153 = 0.090 0.015123 RE = 9.02% = 0.0015123 12.30% CV = /RE 1.3637 Please feel free for any clarifications

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