The effect of financial leverage on ROE 2. The effect of financial leverage on R

Question

The effect of financial leverage on ROE

2. The effect of financial leverage on ROE Aa Aa Companies that use debt in their capital structure are said to be using financial leverage. Using leverage can increase shareholder returns, but leverage also increases the risk that shareholders bear Consider the following case: Mammoth Pictures Inc. is considering a project that will require $650,000 in assets. The project will be financed witlh 10096 equity. The company faces a tax rate of 30%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $145,000? O 15.6% 9.4% 10.9% o Determine what the project's ROE will be if its EBIT is-$50,000. When calculating the tax effects, assume that Mammoth Pictures Inc. as a whole will have a large, positive income this year. O-4.3% O-4.6% 0-54% 0-59%

Explanation / Answer

Answer:

a. the Companies ROE = (EBIT - Tax) x 100 / Equity Funds = $ 145,000 - $ 43,500 (30% tax) / $ 650,000 = 15.61 % or 15.6%. Option A is correct.

b. EBIT = - $ 50,000 and overall there will be possitve profits therefore, - $50,000 loss will save tax to th etune of $ 15,000. Therefore, ROE = -$ 50,000 + $ 15,000 / $ 650,000 = - 5.38% or - 5.4%. Option C is correct answer.

c. EBIT = $ 145,000; Interest = 11% of $ 650,000/2 = $ 35,750; Tax = 30% of ($ 145,000 - $ 35,750) = $ 32,775

ROE = EBIT - Interest - Tax / $ 325,000 (Equity contribution) = $ 76,475 / $ 325,000 = 23.53% or 23.5%. The Correct answer is Option A.

d. EBIT = -$ 50,000; Interest = 11% of $ 650,000/2 = $ 35,750; Saving in Tax = 30% of (-$ 50,000 - $ 35,750) = $ 25,725

ROE = EBIT - Interest - Tax / $ 325,000 (Equity contribution) = -$50,000 - $ 35,750 + $ 25,725 / $ 325,000 = -$60,025 / $ 325,000 = -18.47% or -18.5%. The correct answer is Option C.

e. With the increase in debt content in the Capital Structure the Cost of Equity will increase. This is the common tendency. The correct answer is Option A.

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