Question 1 INTERMEDIATE Arrow Technology, Inc. [ATI) has total assets of $10 million and expected operating income (EBIT) of $2.5 million. If ATl uses debt in its capital structure, the cost of this debt will be 12 percent per annum. 1. Complete the following table: Leverage Ratio (Debt/Total Assets) 0% 25% 50% Total assets Debt (at 12% interest) Equity Total liabilities and equity Expected operating income (EBIT) Less: Interest (at 12%) Earnings before tax Less: Income tax at 40% LT | | Earnings after tax Return on equity Effect of a 20% Decrease in EBIT to $2,000,000 Expected operating income (EBIT) Less: Interest (at 12%) Earnings before tax Less: Income tax at 40% Earnings after tax Return on equity Effect of a 20% Increase in EBIT to $3,000,000 Expected operating income (EBIT) Less: Interest (at 12%) Leverage Ratio (Debt/Total Assets) 0% 25% 50% Earnings before tax Less. Income tax at 40% Earnings after tax Return on equity 2. Determine the percentage change in return on equity of a 20 percent decrease in expected EBIT from a base level of $2.5 million with a debt-to-total-assets ratio of: 1.0% 2.25% 3.50% 3. Determine the percentage change in return on equity of a 20 percent increase in expected EBIT from a base level of $2.5 million with a debt-to-total-assets ratio of: 1. 0% 2.25% 3.50% 4. Which leverage ratio yields the highest expected return on equity? 5. Which leverage ratio yields the highest variability (risk) in expected return on equity? 6. What assumption was made about the cost of debt (that is, interest rate) under the various capital structures (that is, leverage ratios)? How realistic is this assumption? Question 2 INTERMEDIATE Washington Paper Company has estimated the costs of debt and equity capital (with bankruptcy and agency costs) for various proportions of debt in its capital structure as follows: Debt Ratio Pretax Cost Cost of (BAB + B)) of Debt (ks Equity (k) 0.00 14.0% 0.10 70% 142 020 12 146 030 76 154 040 82 170 050 9.0 200 060 100 6.0 The firm's marginal (and average) income tax rate is 40 percent. Determine the company's optimal capital structure. Question 3 Explain what is meant by the clientele effect