5. Business and financial risk As Aa The impact of financial leverage on return

Question

5. Business and financial risk As Aa The impact of financial leverage on return on equity and earnings per share Consider this case: Suppose Khoshjamal Corporation is considering a project that will require $300,000 in assets. The project is expected to produce an EBIT (earnings before interest and taxes) of $45,000. The project will be financed with 100% equity. Common equity outstanding will be 25,000 shares. The company faces a tax rate of 40%. * · Using the preceding information, what will Khoshjamal Corporation's return on equity (ROE) be for this project? 9.90% Q 9.00% 8.10% 9.45% Khoshjamal Corporation's earnings per share (EPS) will be if it finances this project with 100% equity Khoshjamal Corporation's Co is also considering financing this project with SO% debt and 50% equty. The interest rate on the company's debt will be 13%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. What will the ROE be on this project i the company decides to finance the project with 50% debt and 50% equity?

Explanation / Answer

1) Return on equity = EBIT*(1-tax rate)/equity = 45000*(1-0.4)/300000 = 9%

2) EPS = EBIT*(1-tax rate)/no. of shares = 45000*(1-0.4)/25000 = 1.08

3) Return on equity = (EBIT- interest)*(1-tax rate)/equity = (45000- 300000*.13/2)*(1-0.4)/(300000/2) = 10.2%

4) EPS = (EBIT- interest)*(1-tax rate)/no. of shares = (45000- 300000*.13/2)*(1-0.4)/(25000/2) = 1.224

5) When firm uses debt business on equity holders increase because risk of default for firm with debt increases, and upon default equity holders are subordinated over by debt holders

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