Consider the case of American Exports Inc. (AEI):

Suppose American Exports Inc. (AEI) has total assets of $50 million, an expected operating income (EBIT) of $13,000,000, and a tax rate of 40%. The following schedule describes how AEIs interest rate on its borrowed capital changes with the volume of funds borrowed:

In the preceding calculation, AEIs EBIT started at $13,000,000, and then both increased and decreased by 25%. Given what you know about the effect of financial leverage on a firms ROE, you would expect the percentage change in ROE resulting from the increase or decrease in EBIT to be (equal to/less than/more than) a positive or negative 25%, respectively, when the capital structure is unlevered.

What is the percentage change in ROE realized by AEI when it exhibits a 25% debt ratio and its EBIT decreases by 25%?

a. +27.68%

b. -39.10%

c. --27.66%

What is the percentage change in ROE realized by AEI when it exhibits a 75% debt ratio and its EBIT decreases by 25%?

a. --39.10%

b. 25.00%

c. +39.10%

The pattern of these values suggests that the relationship between the amount of financial leverage used and the change in firms ROE is:

a. An indeterminate relationship

b. An inverse relationship

c. A direct relationship

Debt Capital Borrowed $1-$10,000,000 10,000,001-25,000,000 25,000,001-40,000,000 40,000,001-60,000,000 Interest Rate (%) 7.5 10.0 12.5 15.0 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 $13,000,000. 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%. Debt Ratio 0% 25% $50,000,000 $50,000,000 75% $50,000,000 37,500,000 Total assets Total debt Total equity EBIT Less: Interest expense $50,000,000 $13,000,000 $13,000,000 $37,500,000 $13,000,000 1,250,000 11,750,000 4,700,000 Earnings before taxes 13,000,000 $7,800,000 $4,987,500 Less: Tax expense (40%) Net income ROE EBIT Increases by 25% EBIT $16,250,000 $16,250,000 $16,250,000 $6937500 Net income 24.00% ROE EBIT Decreases by 25% EBIT $9,750,000 $9,750,000 $5,850,000 $9,750,000 $3,037,500 Net income ROE 13.60% Debt Capital Borrowed $1-$10,000,000 10,000,001-25,000,000 25,000,001-40,000,000 40,000,001-60,000,000 Interest Rate (%) 7.5 10.0 12.5 15.0 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 $13,000,000. 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%. Debt Ratio 0% 25% $50,000,000 $50,000,000 75% $50,000,000 37,500,000 Total assets Total debt Total equity EBIT Less: Interest expense $50,000,000 $13,000,000 $13,000,000 $37,500,000 $13,000,000 1,250,000 11,750,000 4,700,000 Earnings before taxes 13,000,000 $7,800,000 $4,987,500 Less: Tax expense (40%) Net income ROE EBIT Increases by 25% EBIT $16,250,000 $16,250,000 $16,250,000 $6937500 Net income 24.00% ROE EBIT Decreases by 25% EBIT $9,750,000 $9,750,000 $5,850,000 $9,750,000 $3,037,500 Net income ROE 13.60%