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2. Business and financial risk The impact of financial leverage on return on equity and earnings per share Consider the following case of Lost Pigeon Aviation: Suppose Lost Pigeon Aviation is considering a project that will require $300,000 in assets. - The company is small, so it is exempt from the interest deduction limitation under the new tax law. - The project is expected to produce earnings before interest and taxes (EBIT) of $60,000. - Common equity outstanding will be 15,000 shares. - The company incurs a tax rate of 25%. If the project is financed using 100% equity capital, then Lost Pigeon Aviation's return on equity (ROE) on the project wilt be in addition, Lost Pigeon's earnings per share (EPS) will be Altematively, Lost Pigeon Aviation's CFO is also considering financing the project with 50% debt and 50% equity capital, The interest rate on the company's debt will be 12%, Because the company will finance only 50% of the project with equity, it will have only 7,500 shares outstanding. Lost Pigeon Aylation's ROE and the company's Eps will be if management decides to finance the project with 50% debt and 50% equity. When a firm uses debt financing, the business risk exposure for the firm's common shareholders will