Question

Magic Moose Manufacturing is considering implementing a project that is identical to that being evaluated by Chilly Moose-although Magic Moose wants to finance the $700,000.00 in additional assets using 50% equity and 50% debt capital. The interest rate on Magic Moose's new debt is expected to be 11%, and the project is forecasted to generate an EBIT of $140,000. As a result, the project is expected to generate a ROE of Now assume that Magic Moose finances the same project with 50% debt and 50% equity capital, but expects it to generate an EBIT of only $55,000. 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 Magic Moose's debt is 11%. Under these conditions, it is reasonable to expect that Magic Moose will generate a ROE of: O 3.1%% 2.95% O 3.41% O 3.88% Given the ROE-related findings above for both Chilly Moose and Magic Moose, answer the following question: The use of financial leverage a firm's expected ROE the probability of a the risk borne by the firm's stockholders. large loss, and consequently its optimal debt ratio will be The greater a firm's chance of bankruptcy, the manager is more likely to use debt in an effort to boost profits.

Answer 1

A) Debt 50% 350000 Equity 50%= 350000 Interest rate 11% = Interest charged = 50%*700000 *11% = $38500 Calculation of ROE ЕBIT 140000 Interest (38500) |ЕВT 101500 |Таx @ 35% (35525) 65975 Net Income Equity 350000 ROE = Net Income / Equity 18.85%

в) When EBIT decreases to 55000, ЕBIT 55000 (38500) Interest 16500 ЕВT (5775) Тах 10725 Net Income Equity 350000 ROE = Net Income Equity 3.1% C) The use of financial leverage increases the expected ROE, increase the probability of a large loss, and consequently increase the risk borne by stockholders. The greater the firm's chance of bankruptcy, the lower its optimal debt ratio will be. Aggressive manager is more likely to use debt in an effort to boost profits.