Question

for the first 3 banks ( increase or decrease) , (higher or lower), last one ( aggressive or conservative)

5. The effect of financial leverage on ROE Aa Aa E 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: Purple Panda Products Inc. 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 40%. Assuming that the project generates an expected EBIT (earnings before interest and taxes) of $170,000, then Purple Panda's anticipated ROE (return on equity) for the project will be: O 14.28% 20.40% 22.44% 12.24% O In contrast, assume that the project's EBIT is only $45,000. When calculating the tax effects, assume that the entire Purple Panda Products Inc. will earn a large, positive Income this year. The resulting ROE will be 6.48% 6.21% 4.32% Now consider the case of the Purple Whale Foodstuffs Inc.. 5.40% Purple Whale Foodstuffs Inc. is considering implementing a project that is identical to that being evaluated by Purple Panda-although Purple Whale wants to finance the $500,000.00 in additional assets using 50% equity and 50% debt capital. The interest rate on Purple Whale's new debt is expected to be 12%, and the project is forecasted to generate an EBIT of $170,000. As a result, the project is expected to generate a ROE of Now assume that Purple Whale finances the same project with 50% debt and 50% equity capital, but expects it to generate an EBIT of only $45,000. Further assume that the company as a whole will generate a large, positive income this year, such that any loss generated by the project (with its resulting tax saving) will be offset by the company's other (positive) income. Remember, the interest rate on Purple Whale's debt is 12%. Under these

Answer 1

Answers for Purple Panda Products

1) ROE= Net income /shareholder's equity

Net income = EBIT- Tax @40%

= 170,000-(40% x 170,000) = 102,000

Shareholder's equity here will be entire 500,000 as the project is entire financed via equity.

Hence ROE= 102,000/500,000 = 20.4% (option b)

2) If the project EBIT changes to 45000, then the net income for our case would be = 45,000-(40% x 45000) = 27,000

Shareholder's equity here is same as above

ROE= 27,000/500,000 = 5.4% (option d)

Answers for Purple Whale Foodstuffs Inc.

1) ROE= Net income /shareholder's equity

Shareholder's equity here will be 50 % of 500,000 as the project is financed equally via debt and equity

• Debt @12% interest rate = 250,000
• Shareholder's equity= 250,000

Here Net income will be calculated differently

Earning before taxes=EBIT- interest expenses @12% on 250,000

= 170,000-(12% x 250,000)

= 170,000 - 30,000 = 140,000

Net income= EBT - taxes @40%

= 140,000 - (0.4 x 140,000)

=84,000

Hence ROE= 84,000/250,000 = 33.6% (option D)

2) If the project EBIT changes to 45000, then the net income for our case would be

Earning before taxes = EBIT- interest expenses @12% on 250,000

=45,000-(12% x 250,000)

=45,000 - 30,000 = 15,000

Net income= EBT - taxes @40%

= 15,000 - (0.4 x 15,000)

= 9,000

ROE= 9,000/250,000 = 3.6% (option A)

Fill in the blanks

1) The use of financial leverage increases a firm's expected ROE, decreases or lowers the probability of a large loss, and consequently, lowers or reduces the risk borne by the firm's stockholders.

2) The greater a firm's chance of bankruptcy, the lower its optimal debt ratio will be (since higher debt can lead to higher chances of defaulting on interest payments, the firm would want to avoid that by paying off as much debt and moving closer to its optimal debt ratio)

3) Aggressive (since debt comes with it;s own risks but if used responsibly, it can help in boosting profits of the firm, as can be seen in the 2 cases here)