5. 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:

Green Penguin Pencil Company 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%. Assuming that the project generates an expected EBIT (earnings before interest and taxes) of $140,000, then Green Penguins anticipated ROE (return on equity) for the project will be:

16.33%

13.88%

13.06%

17.96%

In contrast, assume that the projects EBIT is only $40,000. When calculating the tax effects, assume that the entire Green Penguin Pencil Company will earn a large, positive income this year. The resulting ROE will be .

Now consider the case of the Hungry Whale Electronics Company:

Hungry Whale Electronics Company is considering implementing a project that is identical to that being evaluated by Green Penguinalthough Hungry Whale wants to finance the $600,000.00 in additional assets using 50% equity and 50% debt capital. The interest rate on Hungry Whales new debt is expected to be 13%, and the project is forecasted to generate an EBIT of $140,000. As a result, the project is expected to generate a ROE of .

Now assume that Hungry Whale finances the same project with 50% debt and 50% equity capital, but expects it to generate an EBIT of only $40,000. Further assume that the company as a whole will generate a large, positive income this year, such that any loss generated by the project (with its resulting tax saving) will be offset by the companys other (positive) income. Remember, the interest rate on Hungry Whales debt is 13%. Under these conditions, it is reasonable to expect that Hungry Whale will generate a ROE of:

0.23%

0.26%

0.24%

0.2%

Given the ROE-related findings above for both Green Penguin and Hungry Whale, answer the following question:

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