Question

	Leverage ratios (Debt / Total assets)
EBIT = 2,500,500	0%	25%	50%
Total assets	$                                          10,000,000	$   7,500,000	$   5,000,000
Debt (12%)	0	$   2,500,000	$   5,000,000
Equity	$                                          10,000,000	$ 10,000,000	$ 10,000,000
Total liabilities and equity	$                                          10,000,000	$ 12,500,000	$ 15,000,000
Expected operating income (EBIT)	$                                            2,500,000	$   2,500,000	$   2,500,000
Less: Interest (@ 12%)	0	$      300,000	$      600,000
Earnings before tax	$                                            2,500,000	$   2,200,000	$   1,900,000
Less: Income tax @ 40%	$                                            1,000,000	$      880,000	$      760,000
Earnings after tax	$                                            1,500,000	$   1,320,000	$   1,140,000
Return on equity	15%	13.20%	11.40%
Effect of a 20% Decrease in EBIT to $2,000,000	0%	25%	50%
Expected operating income (EBIT)	$                                            2,000,000	$   1,760,000	$   1,520,000
Less: Interest (@ 12%)	$                                            1,000,000	$      880,000	$      760,000
Earnings before tax	$                                            1,000,000	$      880,000	$      760,000
Less: Income tax @ 40%	$                                                400,000	$      352,000	$      304,000
Earnings after tax	$                                                600,000	$      528,000	$      456,000
Return on equity	12%	10.20%	8.40%
Effect of a 20% Increase in EBIT to $3,000,000	0%	25%	50%
Expected operating income (EBIT)	$                                            3,000,000	$   3,000,000	$   3,000,000
Less: Interest (@ 12%)	$                                                400,000	$      352,000	$      304,000
Earnings before tax	$                                            2,600,000	$   2,648,000	$   2,696,000
Less: Income tax @ 40%	$                                            1,040,000	$   1,059,200	$   1,078,400
Earnings after tax	$                                            1,560,000	$   1,588,800	$   1,617,600
Return on equity	6%	7.80%	9.60%

1. Which leverage ratio yields the highest expected return on equity?
2. Which leverage ratio yields the highest variability (risk) in expected return on equity?
3. What assumptions was made about the cost of debt (that is, the interest rates) under the various capital structures (that is, the leverage ratio)? How realistic is the assumption?

Answer 1