1. Which leverage ratio yields the highest expected return on equity?
2. 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?

Leverage ratios (Debt / Total assets)

EBIT = 2,500,500 0% 25% 50%

Total assets $10,000,000 $7,500,000 $5,000,000

Debt (12%) 0 $2,500,000 $5,000,000

Equity $10,000,000 $10,000,000 $10,000,000

Total liabilities and equity $10,000,000 $12,500,000 $15,000,000

Expected operatingincome (EBIT) $2,500,000 $2,500,000 $2,500,000

Less:Interest (@ 12%) 0 $300,000 $600,000

Earnings before tax $2,500,000 $2,200,000 $1,900,000

Less:Income tax @ 40% $1,000,000 $880,000 $760,000

Earnings after tax $1,500,000 $1,320,000 $1,140,000

Return on equity 15% 13.20% 11.40%

Effect of a 20% Decrease in EBIT to $2,000,000 0% 25% 50%

Expected operatingincome (EBIT) $2,000,000 $1,760,000 $1,520,000

Less:Interest (@ 12%) $1,000,000 $880,000 $760,000

Earnings before tax $1,000,000 $880,000 $760,000

Less:Income tax @ 40% $400,000 $352,000 $304,000

Earnings after tax $600,000 $528,000 $456,000

Return on equity 12% 10.20% 8.40%

Effect of a 20% Increase in EBIT to $3,000,000 0% 25% 50%

Expected operatingincome (EBIT) $3,000,000 $3,000,000 $3,000,000

Less:Interest (@ 12%) $400,000 $352,000 $304,000

Earnings before tax $2,600,000 $2,648,000 $2,696,000

Less:Income tax @ 40% $1,040,000 $1,059,200 $1,078,400

Earnings after tax $1,560,000 $1,588,800 $1,617,600

Return on equity 6% 7.80% 9.60%