Question

The Neal Company wants to estimate next year's return on equity (ROE) under different financial leverage ratios. Neal's total capital is $20 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, $1.9 million with a 0.5 probability, and $0.9 million with a 0.3 probability. Calculate Neal's expected ROE, standard deviation, and coefficient of variation for each of the following debt-to-capital ratios. Do not round intermediate calculations. Round your answers to two decimal places at the end of the calculations.

a. Debt/Capital ratio is 0.

RÔE =

σ =

CV =  

b. Debt/Capital ratio is 10%, interest rate is 9%.

RÔE =

σ =

CV =

c. Debt/Capital ratio is 50%, interest rate is 11%.

RÔE =

σ =

CV =

d. Debt/Capital ratio is 60%, interest rate is 14%.

RÔE =

σ =

CV =

Answer 1

a. Debt/Capital ratio is 0.

Debt/Capital ratio of 0 represents there is no debt in the company and hence no interest obligation.

EBIT = Earnings Before Interest and Tax; EBT = Earnings Before Tax; EAT = Earnings After Tax; ROE = Return On Equity

Workings

b. Debt/Capital ratio is 10%

Workings

c. Debt/Capital ratio is 50%

Workings

d. Debt/Capital ratio is 60%

Workings

Summary:

Debt Equity Ratio	ROE	Standard Deviation	Co-efficient of variation
0	6.48%	4.03%	0.621
10%	6.60%	4.47%	0.678
50%	6.36%	8.05%	1.266
60%	3.60%	10.06%	2.795