Question

FINANCIAL LEVERAGE EFFECTS The Neal Company wants to estimate next year's return on equity (ROE) under different financial leverage ratios. Neal's total capital is $13 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: $4.3 million with a 0.2 probability, $1.5 million with a 0.5 probability, and $0.3 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. Debt/Capital ratio is 0. RÕE = CV = Debt/Capital ratio is 10%, interest rate is 9%. RÕE = CV = Debt/Capital ratio is 50%, interest rate is 11%. RÕE = O = CV Debt/Capital ratio is 60%, interest rate is 14%. RÕE = -

Answer 1

=B18/B13 B20 A В с E 1 Total Captial (in $ millions) 13 2 Tax rate 0.4 3 EBIT (in $ million) 4.3 1.5 0.3 4 Probability 0.2 0.5 0.3 5 Expected EBIT (in $ million) -SUMPRODUCT(B3:D3,B4:D4) = B3-$B$5)^2 SUMPRODUCT(B4:D4,B6:D6) 3С3-$B$5)^2 =(D3-$B$5)^2 6 Square of deviation from Expected EBIT 7 Variance -B7/B5 Co-efficient of Variance 8 9 10 Debt/Capital 0 0.1 0.5 0.6 11 Interest rate 0.09 0.11 0.14 | =C10*$B$1 |=SB$1-C12 -SB$5 D10*$B$1 B10*$B$1 =SB$1-B12 E10*$B$1 12 Debt 13 Equity =$B$1-D12 =$B$1-E12 =$B$5 14 Expected EBIT (in $ million) =SB$5 -SB$5 E11*E12 B11*B12 C11*C12 D11*D12 15 Interest 16 EBT B14-B15 D14-D15 E14-E15 C14-C15 |=$B$2*C16 |=C16-C17 =$B$2*B16 -$B$2*D16 SB$2*E16 17 Taxes %3DВ16-B17 18 Net Income =D16-D17 E16-E17 19 =B18/B13 Ес18/с13 20 ROE D18/D13 =E18/E13

fix B18/B13 B20 A В C D Е 1 Total Captial (in $ millions) 13 2 Tax rate 40% 3 EBIT (in $ million) 4.3 1.5 0.3 4 Probability 0.5 0.3 0.2 5 Expected EBIT (in $ million) 1.7 6 Square of deviation from Expected EBIT 0.04 1.96 6.76 7 Variance 1.96 Co-efficient of Variance 8 1.15 9 10 Debt/Capital 0 10% 50% 60% 11 Interest rate 9% 11% 14% 12 Debt 0 1.3 6.5 7.8 13 Equity 14 Expected EBIT (in $ million) 15 Interest 13 11.7 6.5 5.2 1.7 1.7 1.7 1.7 0.00 0.12 0.72 1.09 0.99 0.61 16 EBT 1.70 1.58 0.24 17 Taxes 0.68 0.63 0.39 18 Net Income 1.02 0.95 0.59 0.36 19 20 ROE 7.02% 7.85% 8.12% 9.09%