Question: Analyzing the Impact of Financial Leverage on Return on Equity

ABC Enterprises is evaluating the impact of financial leverage on its return on equity. The

company currently has no debt and is considering taking on $$300,000$ in debt at an interest rate

of $5\%$ per annum to repurchase some of its equity. The repurchase is expected to reduce the

company's equity base by the amount of the debt taken. Before the debt, the company's equity

was $$500,000,$ and it was generating an EBIT $($Earnings Before Interest and Taxes$)$ of $$100,000$

annually. The corporate tax rate is $30\%.$

Calculate the impact of the proposed financial leverage on ABC Enterprises' Return on Equity

$($ROE$).$ Compare the ROE before and after the debt is taken on$.$

Instructions:

Calculate the ROE before the debt, using the formula: $RO{E}_{\text{B}\text{e}\text{f}\text{o}\text{r}\text{e}}=\frac{\text{E}\text{B}\text{I}\text{T}(1-\text{T}\text{a}\text{x}\text{R}\text{a}\text{t}\text{e})}{\text{E}\text{q}\text{u}\text{i}\text{t}\text{y}}$

Calculate the interest expense from the new debt.

Adjust the EBIT for the interest expense to find the net income after the company takes on the

debt.

$$ Calculate the new equity after the debt repurchase.

$$ Calculate the ROE after the debt, using the formula: