Question
Question 1: Arrow Technology (ATI) has total assets of $10 million and expected operating income (EBIT) of $2.5 million. If ATI uses debt in its
Question 1: Arrow Technology (ATI) has total assets of $10 million and expected operating income (EBIT) of $2.5 million. If ATI uses debt in its capital structure, the cost of debt will be 12% per annum.
Complete the following table.
| Leverage Ratio (Debt / Total Assets) | |||
| 0% | 25% | 50% | |
| Total assets |
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| Debt (12%) |
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| Equity |
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| Total liabilities and equity |
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| Expected operating income (EBIT) |
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| Less: Interest (@ 12%) |
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| Earnings before tax |
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| Less: Income tax @ 40% |
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| Earnings after tax |
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| Return on equity |
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| Effect of a 20% Decrease in EBIT to $2,000,000 | |||
| Expected operating income (EBIT) |
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|
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| Less: Interest (@ 12%) |
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|
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| Earnings before tax |
|
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| Less: Income tax @ 40% |
|
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| Earnings after tax |
|
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| Return on equity |
|
|
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| Effect of a 20% Increase in EBIT to $3,000,000 | |||
| Expected operating income (EBIT) |
|
|
|
| Less: Interest (@ 12%) |
|
|
|
| Earnings before tax |
|
|
|
| Less: Income tax @ 40% |
|
|
|
| Earnings after tax |
|
|
|
| Return on equity |
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|
|
Which leverage ratio yields the highest expected return on equity?
Which leverage ratio yields the highest variability (risk) in expected return on equity?
What assumptions was made about the cost of debt (that is, the interest rates) under the various capital structures (that is, the leverage ratio)? How realistic is the assumption?
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Costing
Authors: Lucey
7th Edition
1844809439, 978-1844809431
