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:

Red Snail Satellite Company is considering a project that will require $$650,000$ in assets. The project will be financed with $100\%$ equity. The company

faces a tax rate of $30\%.$ Assuming that the project generates an expected EBIT $($earnings before interest and taxes$)$ of $$170,000,$ then Red Snail's

anticipated ROE $($return on equity$)$ for the project will be:

$13\mathrm{.}73\%$

$18\mathrm{.}31\%$

$12\mathrm{.}82\%$

$20\mathrm{.}14\%$

In contrast, assume that the project's EBIT is only $$50,000.$ When calculating the tax effects, assume that the entire Red Snail Satellite Company will

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 Red Snail$-$although Purple Whale wants

to finance the $$650,000\mathrm{.}00$ in additional assets using $50\%$ equity and $50\%$ debt capital. The interest rate on Purple Whale's new debt is expected to

be $13\%,$ and the project is forecasted to generate an EBIT of $$170,000.$ 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 EBIT of only $$50,000.$

Further assume that the company as a whole will generate a large, positive income this year, such that any loss generated by the project $($with its

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:

$2\mathrm{.}21\%$

$1\mathrm{.}7\%$

$1\mathrm{.}79\%$

$1\mathrm{.}87\%$