Green Penguin Pencil Company is considering a project that will require $$700,000$ in assets. The project will be financed with $100\%$ equity. The company faces a tax rate of $40\%.$ Assuming that the project generates an expected EBIT $($earnings before interest and taxes$)$ of $$170,000,$ then Green Penguin's anticipated ROE $($return on equity$)$ for the project will be:

$12\mathrm{.}38\%$

$10\mathrm{.}20\%$

$8\mathrm{.}74\%$

$14\mathrm{.}57\%$

In contrast, assume that the project's EBIT is only $$40,000.$ When calculating the tax effects, assume that the entire Green Penguin Pencil Company will earn a large, positive income this year. The resulting ROE will be

Now consider the case of the Black Sheep Broadcasting Company:

Black Sheep Broadcasting Company is considering implementing a project that is identical to that being evaluated by Green Penguin$-$although Black Sheep wants to finance the $$700,000\mathrm{.}00$ in additional assets using $50\%$ equity and $50\%$ debt capital. The interest rate on Black Sheep's new debt is expected to be $14\%,$ and the project is forecasted to generate an EBIT of $$170,000.$ As a result, the project is expected to generate a ROE of $$

Now assume that Black Sheep finances the same project with $50\%$ debt and $50\%$ equity capital, but expects it to generate an EBIT of only $$40,000.$ 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 Black Sheep's debt is $14\%.$ Under these conditions, it is reasonable to expect that Black Sheep will generate a ROE of:

$-1\mathrm{.}58\%$

$-1\mathrm{.}35\%$

$-1\mathrm{.}5\%$

$-1\mathrm{.}80\%$

Given the ROE$-$related findings above for both Green Penguin and Black Sheep, 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.