Question

CENGAGE MINDTAP a se Ch 13: Assignment - Capital Structure and Leverage 3. The effect of financial leverage on ROE Companies that use debt in their capital structure are said to be using finandal leverage. Using leverage can increase shareholder retums, but leverage also increases the risk that shareholders bear. Consider the following case: Powers by Irene Inc. is a small company and is considering a project that require $650,000 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 (earings before interest and taxes) of $140,000? 13.73% 11.30% 16.96% 16.15% Determine what the project's ROE will be if its EBIT S - $45,000. When calculating the tax effects, assume that Flowers by Irene Inc. as a whole will have a large, positive income this year, -5.2% -5.98% -5.72% -4.68%

Answer 1

1.) ROE = Net income/shareholders equity

= [140,000 x (1 - 0.25)]/650,000

= 105.000/650,000

= 16.15%

2.) ROE = [-45,000 + saving in tax]/650,000

= [-45,000 + (45,000 x 25%)]/650,000

= (-45,000 + 11,250)/650,000

= -5.2%

3.) Net Income = 140,000 - (650,000/2 x 12%) - (1 - 0.25)

= (140,000 - 39,000) x 0.75 = 75,750

Shareholders equity = 650,000/2 = 325,000

ROE = 75,750/325,000 = 23.31%

4.) Net income = (-45,000 - 39,000) + saving in tax

= -84,000 + (84,000 x 0.25) = -63,000

ROE = -63,000/325,000 = -19.38%

5.) The use of financial leverage Increases the expected ROE, Increases the probability of larger loss, and consequently increases the risk borne by Stockholders. The greater the firm's chance of bankruptcy, the lower its optimal debt ratio will be. A aggressive manager is more likely to use debt in an effort to boost profits.