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The impact of financial leverage on return on equity and earnings per share Consider the following case of Purple Panda Importers: Suppose Purple Panda Importers
The impact of financial leverage on return on equity and earnings per share
Consider the following case of Purple Panda Importers:
Suppose Purple Panda Importers is considering a project that will require $300,000 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 $45,000. | |
Common equity outstanding will be 20,000 shares. | |
The company incurs a tax rate of 25%. |
If the project is financed using 100% equity capital, then Purple Panda Importerss return on equity (ROE) on the project will be __________. In addition, Purple Pandas earnings per share (EPS) will be _________.
first blank
-11.25%
-9.00%
-13.50%
-12.38%
second blank
-$1.27
-$1.18
-$1.69
-$1.86
-$1.61
Alternatively, Purple Panda Importerss 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. Purple Panda Importerss ROE and the companys EPS will be ____________if management decides to finance the project with 50% debt and 50% equity.
16.88% and $2.44
-15.52% and $2.23
-10.13% and $1.62
-13.50% and $2.03
Typically, using financial leverage will ________ a projects expected ROE.
increase
decrease
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