A company has an ROA of 10%. The company has no debt whatsoever (not even trade payables). Its total assets are $1 million and its tax rate is 20%. The company is considering borrowing some money and using the proceeds to buy back outstanding stock. The bank has stated that the interest rate charged will depend on the level of bank debt according to the following schedule: Debt to Equity Interest Rate 0.25 6% 0.50 8% 1.00 10% 1.50 12% 2.00 15%

a. Compute the companys current ROE.

b. Using the formula that relates ROA to ROE and interest costs, calculate the expected ROE for each level of debt.

c. Confirm your calculation by completing the following for each debt level: i. Debt in dollars ii. Equity in dollars iii. Income before interest and taxes (EBIT) iv. Confirm your calculation by completing the following for each debt level:

d. Explain to what extent the use of leverage improves the return on equity (ROE).