Question

The Neal Company wants to estimate next year's return on equity (ROE) under different financial leverage ratios. Neal's total capital is $20 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 25%. The CFO has estimated next year's EBIT for three possible states of the world: $5.5 million with a 0.2 probability, $2.6 million with a 0.5 probability, and $600,000 with a 0.3 probability.

Required:
Calculate Neal's expected ROE, standard deviation, and coefficient of variation.

Answer 1

Answer:

Neal's expected ROE = 4.62%

Neal's standard deviation = 2.46%

Neal's coefficient of variation = 0.53

Explanation:

Note: See the attached excel file for the calculations of Neal's Expected ROE and Deviation.

From the attached excel, we can have:

Neal's expected ROE = Total expected ROE = 0.0462, or 4.62%

Neal's standard deviation = (Total Deviation)^0.5 = 0.00060736^0.5 = 0.0246, or 2.46%

Neal's coefficient of variation = Neal's standard deviation / Neal's expected ROE = 2.46% / 4.62% = 0.53