Problem 14-7 Financial leverage effects The Neal Company wants to estimate next
ID: 2777309 • 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 $14 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: $4.1 million with a 0.2 probability, $2 million with a 0.5 probability, and $400,000 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%.
RÔE = % = % CV =Explanation / Answer
Solution:
Debt Equity = 10 %, interest - 9%
Expected Return EBIT EBIT after Tax Probability Return = EBIT/Total Capital Retun = Probability * Return 4.1 2.46 0.2 17.57% 3.51% 2 1.2 0.5 8.57% 4.29% 0.4 0.24 0.3 1.71% 0.51% Expected Return 8.31%