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
Debt (12%)
Equity
Total liabilities and equity
Expected operating income (EBIT)
Less: Interest (@ 12%)
Earnings before tax
Less: Income tax @ 40%
Earnings after tax
Return on equity
Effect of a 20% Decrease in EBIT to $2,000,000
Expected operating income (EBIT)
Less: Interest (@ 12%)
Earnings before tax
Less: Income tax @ 40%
Earnings after tax
Return on equity
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

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?