Question #3 (12 marks)

The LEO company has an ROA of 10%. The company has a simple balance sheet: TA=TD+TE; Its total assets, TA =$240,000; its tax rate is 20% and its debt-to-equity ratio is [TD/TE] =1/2. The cost of borrowing, before tax, is r= 8%. NIR = r(1-tax rate) is the net interest rate [= 8%(1-.2) = 6.4%]. Spread = ROA NIR.

Required:

Calculate (a) ROE using the formula ROE =ROA + Spread*[TD/TE], (b) the underlying B/S, and I/S; (c) ROA as the weighted average of NIR and ROE.

The marks are; (a) 2 marks, (b) 7 marks, and (c) 3 marks