Question

2. Business and financial risk 

The impact of financial leverage on return on equity and earnings per share 

Consider the following case of Green Rabbit Transportation Inc:

 Suppose Green Rabbit Transportation Inc. is considering a project that will require $350,000 in assets. 

• The project is expected to produce earnings before interest and taxes (EBIT) of $40,000. 

• Common equity outstanding will be 10,000 shares. 

• The company incurs a tax rate of 30%. 

If the project is financed using 100% equity capital, then Green Rabbit Transportation Inc.'s return on equity (ROE) on the project will be _______ . In addition, Green Rabbit's earnings per share (EPS) will be _______ . 

Alternatively, Green Rabbit Transportation 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 5,000 shares outstanding. Green Rabbit Transportation Inc.'s ROE and the company's EPS will be if _______ management decides to finance the project with 50% debt and 50% equity. 

Typically, using financial leverage will _______  a project's expected ROE.

Answer 1