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:

1.) Green Moose Industries is considering a project that will require $650,000 in total assets. The project will be financed with 100% equity, and the company incurs a tax rate of 30%. Assuming that Green Moose's project will earn a an EBIT of $140,000, the project will generate an ROE (return on equity) of ____?

2.) Now assume that the project will generate an EBIT of $-60,000. Assuming that Green Moose, as a whole, will realize a large, positive income this year and the project will continue to be financed with 100% equity funding, the project's ROE will be ____?   . (Hint: The project will incur a tax liability even if it realizes a pre-tax loss. This liability may be offset by tax liabilities produced by other projects and other parts of the company.)

3.) Green Moose is also considering financing the project with 50% equity and 50% debt. The interest rate on the company’s debt will be 8.00%. The project’s ROE—assuming it produces an EBIT of $140,000—will be___? .

4.) What will be the project’s ROE if it produces an EBIT of $-60,000 and it finances 50% of the project with equity and 50% with debt? When calculating the tax effects, assume that Green Moose as a whole will have a large, positive income this year and that any borrowed funds will incur an interest rate of 8.00%.

A) -23.15%

B) -21.30%

C) -18.52%

D) -16.67%

5.) Green Moose Industries 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 Green Moose Industries proceeds with the recapitalization, which of the following items are also likely to increase? Check all that apply.

Return on total assets (ROA)

Basic earning power (BEP)

Net income

Cost of equity (rsrs)

Cost of debt (rdrd)

Answer 1

1. Calculation of return on equity

EBIT= EBT = 140000

Less: tax = 42000

EAT or EAE= 98000

ROE = 98000/650000*100

= 15.08%

2. Now, EBIT = -60000 therefore new earning for equity = (-60000+18000) = -42000

New ROE = (42000)/650000*100 = (6.46%)

3. If the company finances 50% by equity and 50% by debt

EBIT = 140000

Less: interest= 26000

EBT = 114000

Less: tax = 34200

EAT = 79800

ROE = 79800/325000*100 = 24.55%

4. Now EBIT = (60000)

Less: interest = 26000

EBT = (86000)

Add tax saving = 25800

EAE = (60200)

ROE = (60200)/325000*100

= (18.52)%