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Q-3 (20 points) The Impact of Leverage. Consider two companies whose balance sheets differ in only one way, namely their leverage. Company A has a
Q-3 (20 points) The Impact of Leverage. Consider two companies whose balance sheets differ in only one way, namely their leverage. Company A has a debt-equity ratio of 1.5 typical for manufac- turing companies while Company B has a debt-equity ratio of 9, as is common for financial services firms. Suppose that on 12/31/2018 both companies had assets worth $100 million. As- sume for simplicity that in 2019 the companies do not observe any changes to their liabilities. In addition, we assume that in 2019 no dividends were paid, and the net sales of stock is zero. Under each of the following two conditions, construct the companies' respective balance sheets on 12/31/2019 and determine the respective return on equity. (a) Suppose 2019 turns out to be a great year, and the value of assets increases by 10% for both firms. (b) Alternatively, suppose that due to a market downturn both companies lose 10% of their assets. (c) Based on these results, briefly discuss the impact of leverage on a firm's financial results. (Hint: Recall the calculation of "Change in Stockholders' Equity.)
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