Question

consider the Touwing case or Free spurt Ingusules Inc Suppose Free Spirit Industries Inc. is considering a project that will require $250,000 in assets. • The company is small, so it is exempt from the interest deduction limitation under the new tax law. • The project is expected to produce earnings before interest and taxes (EBIT) of $45,000. • Common equity outstanding will be 20,000 shares. . The company incurs a tax rate of 25% . In If the project is financed using 100% equity capital, then Free Spirit Industries Inc.'s return on equity (ROE) on the project will be addition, Free Spirit's earnings per share (EPS) will be Alternatively, Free Spirit Industries Inc.'s CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the company's debt will be 12%. Because the company will finance only 50% of the project with equity, it will have only 10,000 shares outstanding. Free Spirit Industries Inc.'s ROE and the company's EPS will be If management decides to finance the project with 50% debt and 50% equity.

Answer 1

ROE = (EBIT – Interest)(1-Tax Rate)/Equity

When financed with 100% equity, ROE = 45,000(1-25%)/250,000 = 13.5%

EPS = (45,000)(1-25%)/20,000

= $1.6875 per share

When financed with 50% Debt

ROE = (45,000 – 125000*12%)(1-25%)/125000

= 18%

EPS = 2.25 per share

Hence, 18% and $2.25 respectively