Question

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:

Western Gas & Electric Co. is considering a project that will require $500,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 30%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $150,000?

A.) 21.0% C.) 16.8%

B.) 22.1% D.) 13.7%

Determine what the project’s ROE will be if its EBIT is –$40,000. When calculating the tax effects, assume that Western Gas & Electric Co. as a whole will have a large, positive income this year.

A.) -6.4% C.) -5.9%

B.) -5.6% D.) -4.8%

Western Gas & Electric Co. is also considering financing the project with 50% equity and 50% debt. The interest rate on the company’s debt will be 11%. What will be the project’s ROE if it produces an EBIT of $150,000?

A.) 36.0% C.) 32.6%

B.) 34.3% D.) 25.7%

What will be the project’s ROE if it produces an EBIT of –$40,000 and it finances 50% of the project with equity and 50% with debt? When calculating the tax effects, assume that Western Gas & Electric Co. as a whole will have a large, positive income this year.

A.) -18.0% C.) -18.9%

B.) -23.6% D.) -21.7%

D&M Warehousing currently is financed with 10% debt and 90% equity. However, its CFO has proposed that the firm issue new long-term debt and repurchase some of the firm’s common stock. Its advisers believe that the long-term debt would require a before-tax yield of 10%, while the firm’s basic earning power is 14%. The firm’s operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will increase the firm’s stock price. If D&M Warehousing proceeds with the recapitalization, which of the following items are also likely to increase? Choose all that apply.

A.) Cost of equity (rsrs)

B.) Cost of debt (rdrd)

C.) Basic earning power (BEP)

D.) Net income

E.) Return on assets (ROA)

Answer 1

Q1:

ROE=net income/equity

since 100% equity financed, net income=EBIT-taxes =150000*(1-.3) =105000

ROE=105000/500000 =21%

Q2:

ROE=-40000*(1-.3)/500000 = -5.6%

Q3:

Interest expense=11%*.5*500000 =27500

since 50% equity and 50% debt, Equity=250000

net income=EBIT-interest-taxes= (150000-27500)*(1-.3)=85750

ROE=85750/250000 =34.3%

Q4:

ROE=(-40000-27500)*(1-.3)/250000 =-18.9%

Q5:

option A; cost of equity is likely to increase. This is because since the firm is taking more debt which changes its capital structure, the shareholders demand higher returns due to the additional risk they are taking.