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:

Water and Power Co. is considering a project that will require $600,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 30%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $160,000?

15.0%

13.1%

12.2%

18.7%

Determine what the projects ROE will be if its EBIT is $45,000. When calculating the tax effects, assume that Water and Power Co. as a whole will have a large, positive income this year.

-5.5%

-4.4%

-5.2%

-4.7%

Water and Power Co. is also considering financing the project with 50% equity and 50% debt. The interest rate on the companys debt will be 12%. What will be the projects ROE if it produces an EBIT of $160,000?

27.5%

23.1%

21.7%

28.9%

What will be the projects 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 Water and Power Co. as a whole will have a large, positive income this year.

-19.8%

-21.7%

-18.0%

-18.9%

Omni Consumer Products Co. currently is financed with 10% debt and 90% equity. However, its CFO has proposed that the firm issue new long-term debt and repurchase some of the firms common stock. Its advisers believe that the long-term debt would require a before-tax yield of 10%, while the firms basic earning power is 14%. The firms operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will increase the firms stock price. If Omni Consumer Products Co. proceeds with the recapitalization, which of the following items are also likely to increase? Check all that apply.

Return on assets (ROA)

Cost of equity (rsrs)

Net income

Cost of debt (rdrd)

Basic earning power (BEP)