Problem 14-7 Financial leverage effects The Neal Company wants to estimate next
ID: 2707610 • Letter: P
Question
Problem 14-7
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: $4.9 million with a 0.2 probability, $3 million with a 0.5 probability, and $700,000 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.
R
Problem 14-7
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: $4.9 million with a 0.2 probability, $3 million with a 0.5 probability, and $700,000 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.
R
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: $4.9 million with a 0.2 probability, $3 million with a 0.5 probability, and $700,000 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
Pat = EBIT*(1-T)
DEBT/CAPITAL = 0%
EBIT(1-T)
[X]
PROBABILITY [P]
PX
P[(X-MEAN)^2]
A
4.9*0.6
=2.94
0.2
0.588
0.2*[(2.94-1.614)^2]
=0.3517
B
3*0.6
=1.8
0.5
0.9
0.5*[(1.8-1.614)^2]
=0.0173
C
0.7 * 0.6
=0.42
0.3
0.126
0.3[(0.42-1.614)^2]
=0.4277
MEAN PAT=
1.614
VARIANCE = 0.7967
EXPECTED ROE = EXPETED PAT/EQUITY * 100
=1.614/19 * 100
=8.5%
STANDARD DEVIATION = SQUARE ROOT OF 0.7967
=0.89
CO-EFFICIENT OF VARIATION = SD/MEAN * 100
=0.89/1.614 * 100
=55.14%
Pat = EBIT*(1-T)
DEBT/CAPITAL = 0%
EBIT(1-T)
[X]
PROBABILITY [P]
PX
P[(X-MEAN)^2]
A
4.9*0.6
=2.94
0.2
0.588
0.2*[(2.94-1.614)^2]
=0.3517
B
3*0.6
=1.8
0.5
0.9
0.5*[(1.8-1.614)^2]
=0.0173
C
0.7 * 0.6
=0.42
0.3
0.126
0.3[(0.42-1.614)^2]
=0.4277
MEAN PAT=
1.614
VARIANCE = 0.7967
EXPECTED ROE = EXPETED PAT/EQUITY * 100
=1.614/19 * 100
=8.5%
STANDARD DEVIATION = SQUARE ROOT OF 0.7967
=0.89
CO-EFFICIENT OF VARIATION = SD/MEAN * 100
=0.89/1.614 * 100
=55.14%