Companies that use debt in their capital structure are said to be using financial leverage. Using leverage can increase shareholder returns, but leverage also increases the risk that shareholders bear.

Consider the following case:

Water and Power Co$.$ is a small company and is considering a project that will require $$500,000$ in assets. The project will be financed with $100\%$ equity. The company faces a tax rate of $25\%.$ What will be the ROE $($return on equity$)$ for this project if it produces an EBIT $($earnings before interest and taxes$)$ of $$155,000?$

$18\mathrm{.}60\%$

$23\mathrm{.}25\%$

$15\mathrm{.}11\%$

$13\mathrm{.}95\%$

Determine what the project$$s ROE will be if its EBIT is $$$$40,000.$ When calculating the tax effects, assume that Water and Power Co$.$ as a whole will have a large, positive income this year.

$-6\mathrm{.}30\%$

$-5\mathrm{.}10\%$

$-6\mathrm{.}0\%$

$-4\mathrm{.}80\%$

Water and Power Co$.$ is also considering financing the project with $50\%$ equity and $50\%$ debt. The interest rate on the company$$s debt will be $13\%.$ What will be the project$$s ROE if it produces an EBIT of $$155,000?$

$27\mathrm{.}56\%$

$34\mathrm{.}91\%$

$36\mathrm{.}75\%$

$25\mathrm{.}73\%$

What will be the project$$s ROE if it produces an EBIT of $$$$40,000$ and it finances $50\%$ of the project with equity and $50\%$ with debt? When calculating the tax effects, assume that Water and Power Co$.$ as a whole will have a large, positive income this year.

$-21\mathrm{.}75\%$

$-19\mathrm{.}57\%$

$-25\mathrm{.}01\%$

$-20\mathrm{.}66\%$

Allied Biscuit Co$.$ currently is financed with $10\%$ debt and $90\%$ equity. However, its CFO has proposed that the firm issue new long$-$term debt and repurchase some of the firm$$s common stock. Its advisers believe that the long$-$term debt would require a before$-$tax yield of $10\%,$ while the firm$$s basic earning power is $14\%.$ The firm$$s operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will increase the firm$$s stock price. If Allied Biscuit Co$.$ proceeds with the recapitalization, which of the following items are also likely to increase? Check all that apply.

Net income

Basic earning power $($BEP$)$

Cost of equity $($rs$)$

Return on assets $($ROA$)$

Cost of debt $($rd$)$