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6. Arrow Technology, Inc. (ATI) has total assets o...

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6. 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 Ratio (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 a 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 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% 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?

 

Paper#5555 | Written in 18-Jul-2015

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