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 $500,000 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?

15.60%

19.20%

25.20%

24.00%

Determine what the projects ROE will be if its EBIT is $55,000. When calculating the tax effects, assume that Sombra Corp. as a whole will have a large, positive income this year.

-9.43%

-8.2%

-6.97%

-8.61%

Sombra Corp. is also considering financing the project with 50% equity and 50% debt. The interest rate on the companys debt will be 13%. What will be the projects ROE if it produces an EBIT of $160,000?

40.16%

38.25%

36.34%

28.69%