Question

Watson Waterbed Works Inc. has an EBIT of $2.75 million, can borrow at 14% interest, and pays combined state and federal income taxes of 30%. It currently has no debt and is capitalized by equity of $12 million. The firm has 1.5 million shares of common stock outstanding that trade at book value.

1. Calculate Watson's Net Income, ROE and EPS currently and at capital structures that have 20%, 40%, 60%, and 80% debt. Round ROE to one decimal place. Round EPS to two decimal places. Round your Net income answers to the nearest whole thousands. For example, an answer of $200 thousands should be entered as 200, not 200000.

   	All Equity	20% Debt	40% Debt	60% Debt	80% Debt
   Net Income ($000)	$	$	$	$	$
   ROE	%	%	%	%	%
   EPS	$	$	$	$	$

2. Compare the EPS at the different leverage levels, and the amount of change between levels as leverage increases. What happens to the effect of more debt as leverage increases from a little to a lot?
   The effect of leverage accelerates as (Less/More) leverage is added.

Answer 1

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