Companies that use debt in their capital structure are said to be using financial leverage. Using leverage can increase shareholder returns, but Consider the following case: Blue Sky Drone Company is considering a project that will require $700,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 40%. Assuming that the project generates an expected EBIT (earnings before interest and anticipated ROE (return on equity) for the project will be: 9.65%8.36%13.50%12.86% In contrast, assume that the project's EBIT is only $45,000. When calculating the tax effects, assume that the entire Blue Sky earn a large, positive income this year. The resulting ROE will be Now consider the case of the Purple Whale Foodstuffs Inc.: Purple Whale Foodstuffs Inc. is considering implementing a project that is identical to that being evaluated by Blue Sky-although Purple Whale be 13%, and the project is forecasted to generate an EBIT of $150,000. As a result, the project is expected to generate a ROE of Now assume that Purple Whale finances the same project with 50% debt and 50% equity capital, but expects it to generate an $45,000. resulting tax saving) will be offset by the company's other (positive) income. Remember, the interest rate on Purple Whale's debt is 13%. Under these conditions, it is reasonable to expect that Purple Whale will generate a ROE of: 0.09%0.1%0.13%0.12% Given the ROE-related findings above for both Blue Sky and Purple Whale, answer the following question: - The use of financial leverage a firm's expected ROE, the probability of a large loss, and consequently the risk borne by the firm's stockholders. - The greater a firm's chance of bankruptcy, the its optimal debt ratio will be. - manager is more likely to use debt in an effort to boost profits