Business and financial risk

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

Consider the following case of Free Spirit Industries Inc.:

Suppose Free Spirit Industries Inc. is considering a project that will require $200,000 in assets.

	The project is expected to produce earnings before interest and taxes (EBIT) of $55,000.
	Common equity outstanding will be 10,000 shares.
	The company incurs a tax rate of 35%.

If the project is financed using 100% equity capital, then Free Spirits return on equity (ROE) on the project will be ______ . In addition, Free Spirits earnings per share (EPS) will be _________ .

Alternatively, Free Spirit Industries Inc.s CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the companys debt will be 11%. Because the company will finance only 50% of the project with equity, it will have only 5,000 shares outstanding. Free Spirit Industries Inc.s ROE and the companys EPS will be ________ if management decides to finance the project with 50% debt and 50% equity.

Typically, using financial leverage will __Increase/ Decrease_______ a projects expected ROE.