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 $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 million with a 0.2 probability, $1.8 million with a 0.5 probability, and $600,000 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.

Explanation / Answer

Debt/Capital ratio is 0. Probability EBIT Equity Debt Interest Net income= (EBIt-interest)*(1-tax) ROE 0.2 5900000 17000000 0 0 3540000 20.82% 0.5 3100000 17000000 0 0 1860000 10.94% 0.3 500000 17000000 0 0 300000 1.76% Expected ROE = 0.2*20.82% + 0.5*10.94% +0.3*1.76%= 10.16% Std Deviation=sqrt(0.2*(20.82%-10.16%)^2 + 0.5*(10.94%-10.16%)^2 +0.3*(1.76%-10.16%)^2)=6.65% CV=6.65%/10.16%=0.65 Debt/Capital ratio is 10% Probability EBIT Equity Debt Interest Net income= (EBIt-interest)*(1-tax) ROE 0.2 5900000 15300000 1700000 153000 3448200 22.54% 0.5 3100000 15300000 1700000 153000 1768200 11.56% 0.3 500000 15300000 1700000 153000 208200 1.36% Expected ROE = 10.69% Std Deviation=7.39% CV=7.39%/10.69%=0.69 Debt/Capital ratio is 50%, interest rate is 11%. Probability EBIT Equity Debt Interest Net income= (EBIt-interest)*(1-tax) ROE 0.2 5900000 8500000 8500000 935000 2979000 35.05% 0.5 3100000 8500000 8500000 935000 1299000 15.28% 0.3 500000 8500000 8500000 935000 -261000 -3.07% Expected ROE = 13.73% Std Deviation=13.30% CV=13.30%/13.73%=0.97 Debt/Capital ratio is 60%, interest rate is 14%. Probability EBIT Equity Debt Interest Net income= (EBIt-interest)*(1-tax) ROE 0.2 5900000 6800000 10200000 1428000 2683200 39.46% 0.5 3100000 6800000 10200000 1428000 1003200 14.75% 0.3 500000 6800000 10200000 1428000 -556800 -8.19% Expected ROE = 12.81% Std Deviation=16.62% CV=16.62%/12.81%=1.30

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