Question

Attempts: Keep the Highest: /4 2. Business and financial risk Aa Aa ITED The impact of financial leverage on return on equity and earnings per share Catalog Consider the following case of Free Spirit Industries Inc.: Offers utions Suppose Free Spirit Industries Inc. is considering a project that will require $300,000 in assets. • The project is expected to produce earnings before interest and taxes (EBIT) of $60,000. • Common equity outstanding will be 30,000 shares. • The company incurs a tax rate of 40%. Success Center If the project is financed using 100% equity capital, then Free Spirit Industries Inc.'s return on equity (ROE) on the project will be In addition, Free Spirit's earnings per share (EPS) will be eedback DED FOR YOU 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 11%. Because the company will finance only 50% of the project with equity, it will have only 15,000 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. ETUEN RETURN Typically, the use of financial leverage will make the probability distribution of ROIC Rate of Return

Answer 1

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

When financed with 100% equity, ROE = 60,000(1-40%)/300,000 = 12%

EPS = (60,000)(1-40%)/30,000

= $1.2 per share

When financed with 50% Debt

ROE = (60,000 – 150000*11%)(1-40%)/150000

= 17.4%

EPS = 2.9 per share

Hence, 17.4% and $2.9 respectively

INCREASE ROE