Now, to develop an example which can be presented to Pizza Plaza’s management to
ID: 2781677 • Letter: N
Question
Now, to develop an example which can be presented to Pizza Plaza’s management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $25,000 of 6 percent debt. Both firms have $80,000 in assets, a 35 percent tax rate, and an expected EBIT of $15,000.
1. Construct partial income statements, which start with EBIT, for the two firms, .Now calculate ROE for both firms, What does this example illustrate about the impact of financial leverage on ROE?
2. What happens to ROE for Firm U and Firm L if EBIT falls to $4,000? What does this imply about the impact of leverage on risk and return?
3. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.
4. Now calculate the corporate value.
Explanation / Answer
Here, Interest expense = 25,000 x 6% = 1,500
Equity = Total Assets for U and Assets - Debt for L
ROE = Profits / Equity
ROE increases with leverage.
If EBIT = 4,000
In this case, ROE is higher for U than for L
U L EBIT 15,000 15,000 Interest 0 1500 EBT 15,000 13,500 Tax (35%) 5250 4725 Profits 9,750 8,775 Equity 80000 55000 ROE 12.19% 15.95%Related Questions
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