Question

Companies that use debt in their capital structure are said to be using financial leverage. Using leverage can increase shareholder returns, but leverage also increases the risk that shareholders bear.

Consider the following case:

Western Gas & Electric Co. is a small company and is considering a project that will require $500,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 25%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $145,000?

23.93%

13.05%

21.75%

17.40%

Determine what the project’s ROE will be if its EBIT is –$55,000. When calculating the tax effects, assume that Western Gas & Electric Co. as a whole will have a large, positive income this year.

-8.2%

-8.61%

-9.84%

-6.56%

Western Gas & Electric Co. is also considering financing the project with 50% equity and 50% debt. The interest rate on the company’s debt will be 12%. What will be the project’s ROE if it produces an EBIT of $145,000?

37.95%

34.50%

32.78%

24.15%

What will be the project’s ROE if it produces an EBIT of –$55,000 and it finances 50% of the project with equity and 50% with debt? When calculating the tax effects, assume that Western Gas & Electric Co. as a whole will have a large, positive income this year.

-33.15%

-29.32%

-25.50%

-22.95%

The use of financial leverage (increase or decreases) the expected ROE, (increases or decreases) the probability of a large loss, and consequently (increase or decrease) the risk borne by stockholders. The greater the firm’s chance of bankruptcy, the (high or low) its optimal debt ratio will be. (agressive or conservative) manager is more likely to use debt in an effort to boost profits.

Answer 1

Answer a.

Value of Assets = $500,000

Value of Equity = Value of Assets
Value of Equity = $500,000

EBIT = $145,000

Net Income = (EBIT - Interest) * (1 - tax)
Net Income = ($145,000 - $0) * (1 - 0.25)
Net Income = $108,750

Return on Equity = Net Income / Value of Equity
Return on Equity = $108,750 / $500,000
Return on Equity = 21.75%

Answer b.

Value of Assets = $500,000

Value of Equity = Value of Assets
Value of Equity = $500,000

EBIT = -$55,000

Net Income = (EBIT - Interest) * (1 - tax)
Net Income = (-$55,000 - $0) * (1 - 0.25)
Net Income = -$41,250

Return on Equity = Net Income / Value of Equity
Return on Equity = -$41,250 / $500,000
Return on Equity = -8.2%

Answer c.

Value of Assets = $500,000

Value of Equity = 50% * Value of Assets
Value of Equity = 50% * $500,000
Value of Equity = $250,000

Value of Debt = 50% * Value of Assets
Value of Debt = 50% * $500,000
Value of Debt = $250,000

Interest = 12% * Value of Debt
Interest = 12% * $250,000           
Interest = $30,000

EBIT = $145,000

Net Income = (EBIT - Interest) * (1 - tax)
Net Income = ($145,000 - $30,000) * (1 - 0.25)
Net Income = $86,250

Return on Equity = Net Income / Value of Equity
Return on Equity = $86,250 / $250,000
Return on Equity = 34.50%

Answer d.

Value of Assets = $500,000

Value of Equity = 50% * Value of Assets
Value of Equity = 50% * $500,000
Value of Equity = $250,000

Value of Debt = 50% * Value of Assets
Value of Debt = 50% * $500,000
Value of Debt = $250,000

Interest = 12% * Value of Debt
Interest = 12% * $250,000
Interest = $30,000

EBIT = -$55,000

Net Income = (EBIT - Interest) * (1 - tax)
Net Income = (-$55,000 - $30,000) * (1 - 0.25)
Net Income = -$63,750

Return on Equity = Net Income / Value of Equity
Return on Equity = -$63,750 / $250,000
Return on Equity = -25.50%

Answer e.

The use of financial leverage increases the expected ROE, decreases the probability of a large loss, and consequently decreases the risk borne by stockholders. The greater the firm’s chance of bankruptcy, the higher its optimal debt ratio will be. An aggressive manager is more likely to use debt in an effort to boost profits.