Question

1. The effect of financial leverage on ROE 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: Newtown Propane is a small company and is considering a project that will require $700,000 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 $140,000? 9.00% 9.75% 16.50% 15.00% Determine what the project’s ROE will be if its EBIT is –$55,000. When calculating the tax effects, assume that Newtown Propane as a whole will have a large, positive income this year. -7.08% -4.72% -5.02% -5.9% Newtown Propane is also considering financing the project with 50% equity and 50% debt. The interest rate on the company’s debt will be 10%. What will be the project’s ROE if it produces an EBIT of $140,000? 22.50% 24.75% 15.75% 16.88% 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 Newtown Propane as a whole will have a large, positive income this year. -17.36% -25.08% -19.29% -18.33% Demo Inc. currently is financed with 10% debt and 90% equity. However, its CFO has proposed that the firm issue new long-term debt and repurchase some of the firm’s common stock. Its advisers believe that the long-term debt would require a before-tax yield of 10%, while the firm’s basic earning power is 14%. The firm’s operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will increase the firm’s stock price. If Demo Inc. proceeds with the recapitalization, which of the following items are also likely to increase? Check all that apply. Return on assets (ROA) Basic earning power (BEP) Cost of equity (rsrs) Cost of debt (rdrd) Net income

Answer 1

Solution Case 1 Part 1: Calculate ROE Particulars Amount EBIT 140000 Less: Tax (EBIT X Tax Rate) 35000 PAT 105000 Equity 700000 ROE (PAT Equity) 15.0% Hence, Option D 15% is correct Part 2: Calculate ROE Particulars Amount EBIT -55000 Add: Tax Saving (EBIT X Tax Rate) 13750 РАT -41250 Equity 700000 ROE (PAT Equity) -5.9% Hence, Option D -5.9% is correct Part 3: Calculate ROE Particulars Amount EBIT 140000 Less: Interest (700000 X Debt% X interest Rate) 35000 РВT 105000 Less: Tax (EBIT X Tax Rate) 26250 78750 РАT Equity (700000 X Equity %) 350000 ROE (PAT Equity) 22.5% Hence, Option A 22.5% is correct Part 4: Calculate ROE Particulars Amount ЕBIT -55000 Less: Interest (700000 X Debt% X interest Rate) 35000 РВT -90000 Add: Tax Saving (PBT X Tax Rate) 22500 РAT -67500 Equity (700000 X Equity %) 350000 ROE (PAT Equity) -19.29% Hence, Option C -19.29% is correct Note: We are allowed to answer only one question, and only four sub-part of that one question