Due Today at 1159 PM EST 2. The effect of financial leverage on ROE Aa Companies

Question

Due Today at 1159 PM EST 2. The effect of financial leverage on ROE 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: Ziff Corp. is considering a project that will require $650,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 40%, what will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $140,000? 9.0% 12.9% 8.4% 13.5% Determine what the project's ROE will be if its EBIT Is-$50,000. when calculating the tax effects, assume that ziff Corp. as a whole will have a large, positive income this year. 9-4.8% 9-4.6% -5.3% -4.4%

Explanation / Answer

1) Answer (B) 12.9%

EBIT = $140,000

Since there is no interest EAT = $140,000 - ($140,000-40%)

= $84,000

ROE = $84,000 / $650,000

= 12.9%

2) Answer (B) - 4.6%

Calculation :

EBIT = - $50,000

Tax reduction due to negative profit on project = $50,000 * 40%

= $20,000

ROE = (-$50,000 + $20,000) / $650,000

= - 4.6%

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