Question

24. Consider the following leverage scenarios Leverage Scenarios (000s) #2 50% Debt #1 0% Debt #3 80% Debt Capital Debt Equity Total capital Shares $10 Revenue Less costs/ expenses EBIT Interest expense (10%) EBT Taxes @ 40% Earnings after tax ROE EPS $1,600 400 $1,000 1,000 $2,000 $2,000 1,800 200 $2,000 1,800 200 100 100 40 $2,000 1,800 200 160 200 80 16 6% 6% 6% If under certain circumstances, financial leverage enhances performance measured by ROE and EPS, why does shifting from equity into debt have no effect in this case? a. the company hasn't repurchased enough shares of stock with borrowed money b. the money the company is earning on its capital is exactly what it costs to borrow c. ROCE is too higlh d. ROCE is equal to the after tax cost of debt

HELP ME PLEASE!

Answer 1

d. ROCE is equals to the after tax cost of debt

When Return on common Equity (ROCE) is equals to the after tax cost of debt then Weighted Average cost of capital (WACC) remains same for any Debt and Equity Mix ( capital structure) and when WACC and revenue does not change than value of Firm remain same irrespective of change in capital structure. Thus in this case, financial leverage has no effect on ROE and EPS.

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