2. Business and financial risk

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

Consider the following case of Lost Pigeon Aviation:

Suppose Lost Pigeon Aviation is considering a project that will require $300,000 in assets.

	The company is small, so it is exempt from the interest deduction limitation under the new tax law.
	The project is expected to produce earnings before interest and taxes (EBIT) of $55,000.
	Common equity outstanding will be 25,000 shares.
	The company incurs a tax rate of 25%.

If the project is financed using 100% equity capital, then Lost Pigeon Aviations return on equity (ROE) on the project will be . In addition, Lost Pigeons earnings per share (EPS) will be$1.65 .

Alternatively, Lost Pigeon Aviations CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the companys debt will be 10%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. Lost Pigeon Aviations ROE and the companys EPS will be if management decides to finance the project with 50% debt and 50% equity.

Typically, using financial leverage will a projects expected ROE.