Question

The Neal Company wants to estimate next year's return on equity (ROE) under different financial leverage ratios. Neal's total capital is $16 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, $3.2 million with a 0.5 probability, and $0.3 million 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 =

Answer 1

a. Debt/Capital ratio is 0.

RÔE = % ? = % CV =

Excel screen shot as below, formula mentioned in screenshot-

From Excel above:

RÔE = Average ROE = 9.64%, Sigma = SD = 5.83%, CV = Coefficient of Variation = 0.60

(rounded values)

Excel Formula view-

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

RÔE = % ? = % CV =

Excel:

From Excel above:

RÔE = Average ROE = 10.11%, Sigma = SD = 6.47%, CV = Coefficient of Variation = 0.64

(rounded values)

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

RÔE = % ? = % CV =

Excel:

From Excel above:

RÔE = Average ROE = 12.68%, Sigma = SD = 11.65%, CV = Coefficient of Variation = 0.92

(rounded values)

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

RÔE = % ? = % CV =

Excel:

RÔE = Average ROE = 11.49%, Sigma = SD = 14.57%, CV = Coefficient of Variation = 1.27

(rounded values)