Question
Consider the following case of Lost Pigeon Aviation: Suppose Lost Pigeon Aviation is considering a project that will require $350,000 in assets. The company is
Consider the following case of Lost Pigeon Aviation:
Suppose Lost Pigeon Aviation 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 25,000 shares. | |
The company incurs a tax rate of 25%. |
If the project is financed using 100% equity capital, then Lost Pigeon Aviations return on equity (ROE) on the project will be (6.86%,8.57%, 9.00%, 8.14%) . In addition, Lost Pigeons earnings per share (EPS) will be ($1,20, $.84, $1.32, $1.02, $1.08)
Alternatively, Lost Pigeon Aviations CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the companys debt will be 10%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. Lost Pigeon Aviations ROE and the companys EPS will be (10.12% and $1,28; respectively , 10.60% and $1.42;respectively, 9.64% and $1.35; respectively, 7,23% and $1,08; respectively) 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 firms common shareholders will (increase or decrease)
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