Financial leverage effects The Neal Company wants to estimate next year\'s retur
ID: 2779372 • Letter: F
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 $19 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: $4.4 million with a 0.2 probability, $3 million with a 0.5 probability, and $300,000 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%.
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 $19 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: $4.4 million with a 0.2 probability, $3 million with a 0.5 probability, and $300,000 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.
RÔE = % = % CV =Debt/Capital ratio is 10%, interest rate is 9%.
RÔE = % = % CV =Debt/Capital ratio is 50%, interest rate is 11%.
RÔE = % = % CV =Debt/Capital ratio is 60%, interest rate is 14%.
RÔE = % = % CV =Explanation / Answer
Formulae Used:
Mean ROE = = xipi
Where, xi = ROE and pi = probability of that ROE
Standard Deviation = = ( xi2pi )1/2
Coefficient of Variation = /
Tax Rate = 40%
1) Debt/Capital Ratio = 0
Total Capital = $19 million
Equity= $19million
2) Debt/Capital Ratio = 10%
Total Capital = $19 million
Equity= 90% * 19 = $17.1million
Interest Rate = 9%
3) Debt/Capital Ratio = 50%
Total Capital = $19 million
Equity= 50% * 19 = $9.5million
Interest Rate = 11%
4) Debt/Capital Ratio = 60%
Total Capital = $19 million
Equity= 40% * 19 = $7.6million
Interest Rate = 14%
Probability(p) EBIT Debt Interest EBT PAT ROE(x) xp x2p 0.2 4.4 0 0 4.4 2.64 13.89% 2.78% 0.386% 0.5 3 0 0 3 1.8 9.47% 4.74% 0.449% 0.3 0.3 0 0 0.3 0.18 0.95% 0.28% 0.003% 7.80% 0.84% Expected ROE 7.80% Standard Deviation 4.79% CV 0.61Related Questions
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