Now, to develop an example that can be presented to Bernies management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $100,000 of 4 percent debt. Both firms have $500,000 in assets, a 22 percent tax rate, and an expected EBIT of $80,000.

3. Construct partial income statements, which start with EBIT, for the two firms.

4. Now calculate ROE for both firms.

5. What does this example illustrate about the impact of financial leverage on ROE?

6. What happens to ROE for Firm U and Firm L if EBIT falls to $10,000? What does this imply about the impact of leverage on risk and return?