$3.$ The effect of financial leverage on ROE

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:

Sombra Corp. 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?$

$11\mathrm{.}14\%$

$10\mathrm{.}28\%$

$18\mathrm{.}85\%$

$17\mathrm{.}14\%$

Determine what the project$$s ROE will be if its EBIT is $$$$45,000.$ When calculating the tax effects, assume that Sombra Corp. as a whole will have a large, positive income this year.

$-4\mathrm{.}08\%$

$-3\mathrm{.}84\%$

$-5\mathrm{.}76\%$

$-4\mathrm{.}8\%$

Sombra Corp. is also considering financing the project with $50\%$ equity and $50\%$ debt. The interest rate on the company$$s debt will be $12\%.$ What will be the project$$s ROE if it produces an EBIT of $$160,000?$

$18\mathrm{.}97\%$

$27\mathrm{.}82\%$

$17\mathrm{.}70\%$

$25\mathrm{.}29\%$

What will be the project$$s ROE if it produces an EBIT of $$$$45,000$ and it finances $50\%$ of the project with equity and $50\%$ with debt? When calculating the tax effects, assume that Sombra Corp. as a whole will have a large, positive income this year.

$-17\mathrm{.}71\%$

$-16\mathrm{.}78\%$

$-24\mathrm{.}23\%$

$-18\mathrm{.}64\%$

The use of financial leverage the expected ROE, the probability of a large loss, and consequently the risk borne by stockholders. The greater the firm$$s chance of bankruptcy, the its optimal debt ratio will be$.$ manager is more likely to use debt in an effort to boost profits.