Business and financial risk

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

Consider the following case of Green Rabbit Transportation Inc.:

Suppose Green Rabbit Transportation Inc. is considering a project that will require $$250,000$ in assets.

The project is expected to produce earnings before interest and taxes $($EBIT$)$ of $$55,000.$

Common equity outstanding will be $15,000$ shares.

The company incurs a tax rate of $35\%.$

If the project is financed using $100\%$ equity capital, then Green Rabbit's return on equity $($ROE$)$ on the project will be

$.$ In addition,

Green Rabbit's earnings per share $($EPS$)$ will be

Alternatively, Green Rabbit Transportation Inc.$\text{'}$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 $10\%.$ Because the company will finance only $50\%$ of the project with equity, it will have only $7,500$ shares outstanding.

Green Rabbit Transportation Inc.$\text{'}$s ROE and the company's EPS will be

if management decides to finance the

project with $50\%$ debt and $50\%$ equity.

As a firm uses more debt in its capital structure, lenders will usually

the interest rate charged.