8. The effect of financial leverage and earnings changes on the firm's ROE Consider the case of American Importers Inc. (AII): Suppose American Importers Inc. (AII) has total assets of $50 million, an expected operating income (EBIT) of $23,000,000, and a tax rate of 40%. The following schedule describes how AII's interest rate on its borrowed capital changes with the volume of funds borrowed: Use the preceding data to complete the following table and determine how changes in the amount of debt in the capital structure affects the firm's shareholders' return on equity (ROE) under varying levels of EBIT. Remember that the company's initial EBIT is $23,000,000. Determine the changes in the firm's ROE that would occur if the firm's EBIT were to increase by 25% and decrease by 25%. In the preceding calculation, AII's EBIT started at $23,000,000, and then both increased and decreased by 25%. Given what you know about the effect of financial leverage on a firm's ROE, you would expect the percentage change in ROE resulting from the increase or decrease in EBIT to be a positive or negative 25%, respectively, when the capital structure is unlevered. What is the percentage change in ROE realized by AII when it exhibits a 25% debt ratio and its EBIT decreases by 25% ? 26.44% +27.68% 39.10% What is the percentage change in ROE realized by AII when it exhibits a 75% debt ratio and its EBIT decreases by 25% ? 31.40% 25.00% +39.10% The pattern of these values suggests that the relationship between the amount of financial leverage used and the change in firm's ROE is: A direct relationship An indeterminate relationship An inverse relationship