The impact of financial leverage on return on equity and earnings per share Cons
ID: 2784495 • Letter: T
Question
The impact of financial leverage on return on equity and earnings per share Consider the following case of Lost Pigeon Aviation: Suppose Lost Pigeon Aviation is considering a project that will require $250,000 in assets The project is expected to produce earnings before interest and taxes (EBIT) of $55,000. Common equity outstanding will be 20,000 shares. · The company incurs a tax rate of 35%. If the project is financed using 100% equity capital, then Lost Pigeon Aviation's return on equity (ROE) on the project will be In addition, Lost Pigeon's earnings per share (EPS) will be Alternatively, Lost Pigeon Aviation's CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the company's debt will be 10%. Because the company will finance only 50% of the project with equity, it will have only 10,000 shares outstanding. Lost Pigeon Aviation's ROE and the company's EPS will be equity if management decides to finance the project with 50% debt and 50% When a firm uses debt financing, the business risk exposure for the firm's common shareholders willExplanation / Answer
When firm uses all equity in the project , Firms Net Profit will be EBIT(1-t)
Net income = 55000*(1-0.35)= $35750
ROE= PAT / EQUITY= 35750/250000= 0.143= 14.30%
EPS= PAT/ No. of shares= 35750/20000= $1.7875 or $1.79 per share
When firm uses 50% debt and 50% equity , then firms net income will be: EBIT- Interest- Tax
EBIT 55000
Interest( 125000*0.10) = 12500
PBT = 42500
PAT [PBT*(1-t)] $27625
ROE= PAT / EQUITY= 27625/250000= 0.1105= 11.05%
EPS= PAT/ No. of shares= 27625/20000= $1.38 or $1.38 per share
when firm using the debt financing , there will be no change in business risk(operating risk ) exposure i.e., business risk will be reflected by its fixed cost.
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