16.2

a. Every change of $50,000 in operating income leads to a change in the return to equityhold- ers of 20%. This is double the swing in equity returns when debt was only $500,000.

b. The stockholder should lend out $3 for every $1 invested in River Cruises's stock. For example, he could buy one share for $10 and then lend $30. The payoffs are:

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Data Number of shares Price per share Market value of shares 25,000 $10 $250,000 Market value of debt $750,000 State of the Economy Slump Normal Boom Operating income, dollars 75,000 125,000 175,000 Interest, dollars 75,000 75,000 75,000 Equity earnings, dollars 0 50,000 100,000 Earnings per share, dollars 0 2.00 4.00 Return on shares 0% 20% 40%