An entrepreneur is planning to establish a company with $50 million in assets

and is investigating three possible capital structures for the company: (i) no debt;

(ii) 20 per cent debt; and (iii) 50 per cent debt. The interest rate on the debt is 10

per cent per annum. The entrepreneur believes that the annual earnings before

interest and tax will be $2.5 million in a poor year, $5 million in an average year

and $10 million in a good year.

(a)Complete the table below.

Capital structure (i)Capital structure (ii)Capital structure (iii)

Assets

Debt/Assets

Debt ($)

Equity ($)

EBIT ($)$2.5m$5m$10m $2.5m$5m$10m $2.5m$5m$10m

Interest ($)

Net income ($)

ROA (%)(a)

ROE (%)(b)

(1) ROA (Return on Assets) = EBIT / Assets (where EBIT means earnings before interest and tax)

(2) ROE (Return on Equity) = Net income / Equity

(b)Plot the results for the three capital structures together on one diagram,

with return on assets (ROA) on the vertical axis. Comment.