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

Consider the following case of Happy Turtle Transportation Company:

Suppose Happy Turtle Transportation Company is considering a project that will require $400,000 in assets.

	The project is expected to produce earnings before interest and taxes (EBIT) of $40,000.
	Common equity outstanding will be 30,000 shares.
	The company incurs a tax rate of 40%.

If the project is financed using 100% equity capital, then Happy Turtle Transportation Companys return on equity (ROE) on the project will be___________.

A.) 4.80% C.) 6.60%

B.) 6.00% D.) 5.40%

In addition, Happy Turtles earnings per share (EPS) will be________.

A.) $0.56 C.) $0.80 E.) $0.76

B.) $0.88 D.) $0.64

Alternatively, Happy Turtle Transportation Companys CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the companys debt will be 10%. Because the company will finance only 50% of the project with equity, it will have only 15,000 shares outstanding. Happy Turtle Transportation Companys ROE and the companys EPS will be____________if management decides to finance the project with 50% debt and 50% equity.

A.) 5.70% and $0.72, respectively

B.) 4.50% and $0.64, respectively

C.) 6.00% and $0.80, respectively

D.) 6.90% and $0.88, respectively

Typically, using financial leverage will________a projects expected ROE.

A.) Increase

B.) Decrease