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: Wizard Co. 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 30%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $160,000? O 12.8% O 16.0% O 16.8% 10.4% Determine what the project's ROE will be if its EBIT is -$60,000. When calculating the tax effects, assume that Wizard Co. as a whole will have a large, positive income this year. O-6.0% O-4.8% O -7,2% O-5.1% Wizard Co. is also considering financing the project with 50% equity and 50% debt. The interest rate on the company's debt will be 11%. What will be the project's ROE if it produces an EBIT of $160,000? O 26.7% O 24.3% O 18.2% O 19.4% What will be the project's ROE if it produces an EBIT of -$60,000 and it finances 50% of the project with equity and 50% with debt? When calculating the tax effects, assume that Wizard Co. as a whole will have a large, positive income this year. O-17.7% O -19.7% O-22.7% -21.7% 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) Cost of debt (rd) Basic earning power (BEP) Net income Cost of equity (rs)

Answer 1

Answer to Question 1.

As Wizard Co. is 100% financed with equity, therefore,
Total Equity = Total Assets
Total Equity = $700,000

Net Income = (EBIT – Interest) * (1 – Tax Rate)
Net Income = ($160,000 - $0) * (1 – 0.30)
Net Income = $112,000

Return on Equity = Net Income / Total Equity * 100
Return on Equity = $112,000 / $700,000 * 100
Return on Equity = 16.0%

Answer to Question 2.

Net Income = (EBIT – Interest) * (1 – Tax Rate)
Net Income = ($-60,000 - $0) * (1 – 0.30)
Net Income = -$42,000

Return on Equity = Net Income / Total Equity * 100
Return on Equity = -$42,000 / $700,000 * 100
Return on Equity = -6.0%

Answer to Question 3.

As Wizard Co. is 50% financed with equity and 50% with debt, therefore,
Total Equity = Total Assets * 50%
Total Equity = $700,000 * 50% = $350,000

Total Debt = Total Assets * 50%
Total Debt = $700,000 * 50% = $350,000

Interest Expense = $350,000 * 11%
Interest Expense = $38,500

Net Income = (EBIT – Interest) * (1 – Tax Rate)
Net Income = ($160,000 - $38,500) * (1 – 0.30)
Net Income = $85,050

Return on Equity = Net Income / Total Equity * 100
Return on Equity = $85,050 / $350,000 * 100
Return on Equity = 24.3%

Answer to Question 4.

Net Income = (EBIT – Interest) * (1 – Tax Rate)
Net Income = ($-60,000 - $38,500) * (1 – 0.30)
Net Income = -$68,950

Return on Equity = Net Income / Total Equity * 100
Return on Equity = -$68,950 / $350,000 * 100
Return on Equity = -19.7%