Question

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: Flowers by Irene Inc. is a small company and is considering a project that will require $700,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 25%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $160,000? 11.14% 17.14% 12.86% 14.57% Determine what the project's ROE will be if its EBIT is -$60,000. When calculating the tax effects, assume that Flowers by Irene Inc. as a whole will have a large, positive income this year. -5.44% 0 -6.4% -7.04%

Answer 1

1.)	ROE	17.14%	(160,000 x ( 1 -25% ) )
	Correct answer is option 2 (i.e. 17.14% ).
2.)	ROE	-6.4%	(-60,000 x ( 1- 25% ) )
	Correct answer is option 2 (i.e. -6.4% ).
3.)		Amount in $
	EBIT	160,000
	Less: Interest	35,000
	EBT	125,000
	Less: Tax @25%	31,250
	Earning after tax	93,750
	ROE	26.79%	( 93,750 / (700,000 x 50% ) )
	Correct answer is option 3 (i.e. 26.79% ).
4.)		Amount in $
	EBIT	-60,000
	Less: Interest	35,000
	EBT	-95,000
	Add: Tax benefit @25%	23,750
	Earning after tax	-71,250
	ROE	-20.36%	(-71,250 / ( 700,000 x 50% ) )
	Correct answer is option 1 (i.e. -20.36% ).
5.)	As the debt increases, the cost of debt increases as well. Higher leverage means more risk and hence, cost of equity increases as well.
	Net Income will decrease because of increased interest expense, while the assets would be constant. Hence, ROA will likely be lower. BEP = EBIT / Assets will like to remain constant.