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:

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 (that is, interest rate) under
the various capital structures (that is, leverage ratios)? How realistic is this
assumption?