Ohio Quarry Inc. has $12 million in assets. Its expected operating income (EBIT) is $2 million and its income tax rate is 40 percent. If Ohio Quarry finances 20 percent of its total assets with debt capital, the pretax cost of funds is 10 percent. If the company finances 40 percent of its total assets with debt capital, the pretax cost of funds is 15 percent.
a. Determine the rate of return on equity (ROE) under the three different capital structures (0, 20, and 40% debt ratios).
b. Which capital structure yields the highest expected ROE?
c. Determine the ROE under each of the three capital structures (0, 20, and 40% debt ratios) if expected EBIT decreases by 20 percent.
d. Which capital structure yields the highest ROE calculated in part c?
e. Determine the percentage change in ROE under each of the three capital structures (that is, debt ratios) as the result of a 20 percent decline in EBIT.
f. Based on the results in part e, which capital structure yields the highest variability (that is, risk) in ROE?
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