Business and financial risk

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

Consider the following case of Purple Panda Importers:

Suppose Purple Panda Importers is considering a project that will require $$350,000$ 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 $$40,000.$

Common equity outstanding will be $30,000$ shares.

The company incurs a tax rate of $25\%.$

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

$.$ In

addition, Purple Panda's earnings per share $($EPS$)$ will be

Alternatively, Purple Panda Importers'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 $11\%.$ Because the company will finance only $50\%$ of the project with equity, it will have only $15,000$ shares outstanding. Purple

Panda Importers'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