5. Business and financial risk

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

Consider the following case of Happy Turtle Transportation Company:

Suppose Happy Turtle Transportation Company is considering a project that will require $200,000 in assets.

	The project is expected to produce earnings before interest and taxes (EBIT) of $40,000.
	Common equity outstanding will be 15,000 shares.
	The company incurs a tax rate of 35%.

1. If the project is financed using 100% equity capital, then Happy Turtles return on equity (ROE) on the project will be (14.30%, 12.35%, 14.95%,13.00%). In addition, Happy Turtles earnings per share (EPS) will be ($1.64, $1.47, $1.56, $1.73, $1.82). .

2. Alternatively, Happy Turtle Transportation Companys CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the companys debt will be 13%. Because the company will finance only 50% of the project with equity, it will have only 7,500 shares outstanding. Happy Turtle Transportation Companys ROE and the companys EPS will be (21.60 and 2.69, respectively, 18.43 and 2.22, respectively, 17.55 and 2.34, respectively, 10.18 and 2.57, respectively) if management decides to finance the project with 50% debt and 50% equity.

3. When a firm uses debt financing, the business risk exposure for the firms common shareholders will (increase or decrease).

*All answer options are bolded*