2. Business and financial risk

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

Consider the following case of Purple Panda Importers:

Suppose Purple Panda Importers is considering a project that will require $200,000 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 $50,000.
	Common equity outstanding will be 30,000 shares.
	The company incurs a tax rate of 25%.

If the project is financed using 100% equity capital, then Purple Panda Importerss return on equity (ROE) on the project will be . In addition, Purple Pandas earnings per share (EPS) will be .

Alternatively, Purple Panda Importerss CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the companys debt will be 12%. Because the company will finance only 50% of the project with equity, it will have only 15,000 shares outstanding. Purple Panda Importerss ROE and the companys EPS will be if management decides to finance the project with 50% debt and 50% equity.

When a firm uses debt financing, the business risk exposure for the firms common shareholders will .