The Neal Company wants to estimate next year\'s return on equity (ROE) under dif

Question

The Neal Company wants to estimate next year's return on equity (ROE) under different leverage ratios. Neal's total capital is $12 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: $6 million with a 0.2 probability, $2.7 million with a 0.5 probability, and $800,000 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.

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

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

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

Explanation / Answer

(A) No Debt ($ in millions) Probability Expected Return Tax Net Return Return Devation for Expected Value Squared Probable return 0.2 6 2.4 3.6 0.72 0.63 0.40 0.07938 0.5 2.7 1.08 1.62 0.81 -1.35 1.82 0.91125 0.3 8 3.2 4.8 1.44 1.83 3.35 1.00467 1 10.02 2.97 5.57 1.9953 Total Equity 12 ROE 24.75% Standard Deviation 1.41 Coefficient of Variation 0.48 (B) Debt is 10% and Int is 9% ($ in millions) Probability Expected Return Interest @9% Return after Int Tax Net Return Return Devation for Expected Value Squared Probable return 0.2 6 0.108 5.892 2.3568 3.5352 0.707 0.63 0.40 0.07938 0.5 2.7 0.108 2.592 1.0368 1.5552 0.7776 -1.35 1.82 0.91125 0.3 8 0.108 7.892 3.1568 4.7352 1.4206 1.83 3.35 1.00467 1 9.8256 2.9052 5.57 1.9953 Total Equity 10.8 ROE 26.90% Standard Deviation 1.41 Coefficient of Variation 0.49 (C) Debt is 50% and Int is 11% ($ in millions) Probability Expected Return Interest @11% Return after Int Tax Net Return Return Devation for Expected Value Squared Probable return 0.2 6 0.66 5.34 2.136 3.204 0.6408 0.63 0.40 0.07938 0.5 2.7 0.66 2.04 0.816 1.224 0.612 -1.35 1.82 0.91125 0.3 8 0.66 7.34 2.936 4.404 1.3212 1.83 3.35 1.00467 1 8.832 2.574 5.57 1.9953 Total Equity 6 ROE 42.90% Standard Deviation 1.41 Coefficient of Variation 0.55 (D) Debt is 60% and Int is 14% ($ in millions) Probability Expected Return Interest @14% Return after Int Tax Net Return Return Devation for Expected Value Squared Probable return 0.2 6 1.008 4.992 1.9968 2.9952 0.599 0.63 0.40 0.07938 0.5 2.7 1.008 1.692 0.6768 1.0152 0.5076 -1.35 1.82 0.91125 0.3 8 1.008 6.992 2.7968 4.1952 1.2586 1.83 3.35 1.00467 1 8.2056 2.3652 5.57 1.9953 Total Equity 4.8 ROE 49.28% Standard Deviation 1.41 Coefficient of Variation 0.60

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.