80.2K

Verified Solution

Link Copied!

Suppose Exeter Importers Inc. has total assets of $50 million, an expected operating income (EBIT) of $15,000,000, and a tax rate of 35%. The following schedule describes how Exeter's interest rate on its borrowed capital changes with the volume of funds borrowed: Interest Rate (%) Debt Capital Borrowed $1-$10,000,000 7.5 10.0 10,000,001-25,000,000 25,000,001-40,000,000 40,000,001-60,000,000 12.5 15.0 Use the preceding data to complete the following table and determine how changes in the amount of debt in the capital structure affects the firm's shareholders' return on equity (ROE) under varying levels of EBIT. Remember that the company's initial EBIT is $15,000,000. Determine the changes in the firm's ROE that would occur if the firm's EBIT were to increase by 25% and decrease by 25%. Debt Ratio 0% 25% Total assets $50,000,000 $50,000,000 75% $50,000,000 37,500,000 Total debt Total equity $50,000,000 $15,000,000 EBIT $15,000,000 Less: Interest expense $37,500,000 $15,000,000 1,250,000 13,750,000 4,812,500 15,000,000 Earnings before taxes Less: Tax expense (35%) Net income $9,750,000 $6,703,125 ROE EBIT Increases by 25% EBIT $18,750,000 $18,750,000 $18,750,000 $9140625 Net income ROE 30.33% EBIT Decreases by 25% EBIT $11,250,000 $11,250,000 $11,250,000 $7,312,500 Net income $4,265,625 ROE 17.33% In the preceding calculation, Exeter's EBIT started at $15,000,000, and then both increased and decreased by 25%. Given what you know about the effect of financial leverage on a firm's ROE, you would expect the percentage change in ROE resulting from the increase or decrease in EBIT to be a positive or negative 25%, respectively, when the capital structure is unlevered. What is the percentage change in ROE realized by Exeter when it exhibits a 25% debt ratio and its EBIT increases by 25%? -27.68% +25.00% O +27.28% What is the percentage change in ROE realized by Exeter when it exhibits a 75% debt ratio and its EBIT increases by 25%? +36.36% O +27.68% O -25.00% The pattern of these values suggests that the relationship between the amount of financial leverage used and the change in firm's ROE is: O An indeterminate relationship O A direct relationship O An inverse relationship Suppose Exeter Importers Inc. has total assets of $50 million, an expected operating income (EBIT) of $15,000,000, and a tax rate of 35%. The following schedule describes how Exeter's interest rate on its borrowed capital changes with the volume of funds borrowed: Interest Rate (%) Debt Capital Borrowed $1-$10,000,000 7.5 10.0 10,000,001-25,000,000 25,000,001-40,000,000 40,000,001-60,000,000 12.5 15.0 Use the preceding data to complete the following table and determine how changes in the amount of debt in the capital structure affects the firm's shareholders' return on equity (ROE) under varying levels of EBIT. Remember that the company's initial EBIT is $15,000,000. Determine the changes in the firm's ROE that would occur if the firm's EBIT were to increase by 25% and decrease by 25%. Debt Ratio 0% 25% Total assets $50,000,000 $50,000,000 75% $50,000,000 37,500,000 Total debt Total equity $50,000,000 $15,000,000 EBIT $15,000,000 Less: Interest expense $37,500,000 $15,000,000 1,250,000 13,750,000 4,812,500 15,000,000 Earnings before taxes Less: Tax expense (35%) Net income $9,750,000 $6,703,125 ROE EBIT Increases by 25% EBIT $18,750,000 $18,750,000 $18,750,000 $9140625 Net income ROE 30.33% EBIT Decreases by 25% EBIT $11,250,000 $11,250,000 $11,250,000 $7,312,500 Net income $4,265,625 ROE 17.33% In the preceding calculation, Exeter's EBIT started at $15,000,000, and then both increased and decreased by 25%. Given what you know about the effect of financial leverage on a firm's ROE, you would expect the percentage change in ROE resulting from the increase or decrease in EBIT to be a positive or negative 25%, respectively, when the capital structure is unlevered. What is the percentage change in ROE realized by Exeter when it exhibits a 25% debt ratio and its EBIT increases by 25%? -27.68% +25.00% O +27.28% What is the percentage change in ROE realized by Exeter when it exhibits a 75% debt ratio and its EBIT increases by 25%? +36.36% O +27.68% O -25.00% The pattern of these values suggests that the relationship between the amount of financial leverage used and the change in firm's ROE is: O An indeterminate relationship O A direct relationship O An inverse relationship

Answer & Explanation Solved by verified expert

See Answer