Arrow Technology, Inc. (ATI) has total assets of $10 million and expected operating income (EBIT) of $2.5 million. If ATI uses debt in its capital structure, the cost of this debt will be 12 percent per annum.

a. Complete the following table:

Leverage ration (debt/total assets)

0% 25% 50%

Total assets

Debt (at 12% interest)

Equity

Total liabilities and equity

Expected operating income (EBIT)

Less: Interest (at 12%)

Earnings before tax

Less: Income tax at 40%

Earnings after tax

Return on equity

effect of 20% decrease In EBIT to $2,000,000

Expected operating income (EBIT)

Less: Interest (at 12%)

Earnings before tax

Less: Income tax at 40%

Earnings after tax

Return on equity

effect of a 20% increase in EBIT to $3,000,000

Expected operating income (EBIT)

Less: Interest (at 12%)

Earnings before tax

Less: Income tax at 40%

Earnings after tax

Return on equity

b. Determine the percentage change in return on equity of a 20 percent decrease in expected EBIT from a base level of $2.5 million with a debt-to-total-assets ratio of

i. 0%

ii. 25%

iii. 50%

c. Determine the percentage change in return on equity of a 20 percent increase expected EBIT from a base level of $2.5 million with a debt-to-total-assets ratio of

i. 0%

ii. 25%

iii. 50%

d. Which leverage ratio yields the highest expected return on equity?

e. Which leverage ratio yields the highest variability (risk) in expected return on equity?

f. What assumption was made about the cost of debt (i.e., interest rate) under the various capital structures (i.e., leverage ratios)? How realistic is this assumption?

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