The impact of financial leverage on return on equity and earnings per share

Consider the following case of Lost Pigeon Aviation:

Suppose Lost Pigeon Aviation is considering a project that will require $250,000 in assets.

	The project is expected to produce earnings before interest and taxes (EBIT) of $40,000.
	Common equity outstanding will be 20,000 shares.
	The company incurs a tax rate of 40%.

If the project is financed using 100% equity capital, then Lost Pigeons return on equity (ROE) on the project will be . In addition, Lost Pigeons earnings per share (EPS) will be .

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 12%. Because the company will finance only 50% of the project with equity, it will have only 10,000 shares outstanding. Lost Pigeon Aviations ROE and the companys EPS will be if management decides to finance the project with 50% debt and 50% equity.

As a firm uses more debt in its capital structure, lenders will usually the interest rate charged.