Question

The Neal Company wants to estimate next year's return on equity (ROE) under different financial leverage ratios. Neal's total capital is $15 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 million with a 0.2 probability, $2.2 million with a 0.5 probability, and $0.4 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 = %

σ = %

CV =

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

RÔE = %

σ = %

CV =

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

RÔE = %

σ = %

CV =

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

RÔE = %

σ = %

CV =

Answer 1

Answer:

(A) Debt/Capital ratio is 0.

RÔE = 8.08%

σ = 5.04%

CV = 0.62

(B) Debt/Capital ratio is 10%, interest rate is 9%.

RÔE = 8.38%

σ = 5.60%

CV = 0.67

(C) Debt/Capital ratio is 50%, interest rate is 11%.

RÔE = 9.56%

σ = 10.08%

CV = 1.05

(D) Debt/Capital ratio is 60%, interest rate is 14%.

RÔE = 7.60%

σ = 12.60%

CV = 1.66

Workings: