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

ID: 2793963 • Letter: T

Question

The impact of financial leverage on return on equity and earnings per share Consider the following case of Green Rabbit Transportation Inc. Suppose Green Rabbit Transportation Inc. is considering a project that will require $250,000 in assets. The project is expected to produce earnings before interest and taxes (EBIT) of $60,000 Common equity outstanding will be 25,000 shares. · The company incurs a tax rate of 30%. If the project is financed using 100% equity capital, then Green Rabbit Transportation Inc.'s return on equity (ROE) on the project will be . In addition, Green Rabbit's earnings per share (EPS) will be Alternatively, Green Rabbit Transportation Inc.'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 12%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. Green Rabbit Transportation Inc.'s ROE and the company's EPS will be 50% debt and 50% equity. if management decides to finance the project with As a firm uses more debt in its capital structure, lenders will usually the interest rate charged

Explanation / Answer

EBIT = $60,000

Tax rate = 30%

If company financed total with equity then

Net Income = $60,000 × (1 - 30%)

= $42,000

Net income of company is $42,000.

Return on Equity = $42,000 / $250,000

= 16.80%

If company financed total with equity then return on equity will be 16.80%.

Earnings per share = $42,000 / 25,000

= $1.68

Earning per share is $1.68.

b.

Value of assets = $250,000

Value of debt = $125,000

Interest on debt = $125,000 × 12%

= $15,000

Now, Net income = ($60,000 - $15,000) × (1 - 30%)

= $45,000 × 70%

= $31,500

Net income in this case is $31,500.

Earning per share = $31,500 / 12,500

= $2.52

Earning per share in this case is $2.52.

Return on equity = $31,500 / $125,000

= 25.20%

If company finance 50% of its assets with debt the earning per share would be $2.52 and return on equity is 25.20%.