Watson Waterbed Works Inc. has an EBIT of $2.75 million, can borrow at 15% interest, and pays combined state and federal income taxes of 40%. It currently has no debt and is capitalized by equity of $12 million. The firm has 1.5 million shares of common stock outstanding that trade at book value.
a. Calculate Watson's EAT, ROE, and EPS currently and at capital structures that have 20%, 40%, 60%, and 80% debt.
b. Compare the EPS at the different leverage levels, and the amount of change between levels as leverage increases. What happens to the effect of more debt as leverage increases from a little to a lot?