Question Seven: FINANCIAL LEVERAGE EFFECTS. The Neal Company wants to estimate next years return on equity (ROE) under different financial leverage ratios. Neals total capital is $14 million, it currently uses only common equity, it has no future plans to use preferred stock in its capital structure, and its federal-plus-state tax rate is 40%. The CFO has estimated next years EBIT for three possible states of the world: $4.2 million with a 0.2 probability, $2.8 million with a 0.5 probability, and $700,000 with a 0.3 probability. Calculate Neals expected ROE, standard deviation, and coefficient of variation for each of the following debt-to-capital ratios; then evaluate the results:

Debt/Capital Ratio Interest Rate

0% --

10 9%

50 11

60 14