Question

Suppose Purple Turtle Group is considering a project that will require $600,000 in total assets. The project is expected to produce an EBIT (earnings before interest and taxes) of $70,000, and will be financed with 100% equity. The company has a 35% tax rate and has 10,000 shares of common stock outstanding.

The return on equity (ROE) on Purple Turtle’s project will be (6.06,7.58,8.34,9.10)   .

If the project is financed with 100% equity, the Purple Turtle’s earnings per share (EPS) will be (3.18,4.32,4.55,5.01)   .

Purple Turtle’s CFO is also considering financing this project with 50% debt and 50% equity. The interest rate on the company’s debt is expected to be 9%. Because the company will finance only 50% of the project with equity, it will have only 5,000 shares outstanding. If the company decides to finance the project with 50% debt and 50% equity, the project's ROE will be (6.99,9.32,10.72,11.65)   .

Purple Turtle’s EPS will be (4.47,5.59,6.15,6.71) if it finances this project with 50% equity and 50% debt.

Typically, the use of financial leverage will make the probability distribution of ROIC (stepper,flatter) .

Answer 1

Answer a.

Net Income = (EBIT - Interest Expense) * (1 - tax)
Net Income = ($70,000 - $0) * (1 - 0.35)
Net Income = $45,500

Value of Equity = $600,000

ROE = Net Income / Value of Equity
ROE = $45,500 / $600,000
ROE = 7.58%

Answer b.

EPS = Net Income / Number of shares outstanding
ROE = $45,500 / 10,000
ROE = $4.55

Answer c.

Value of Assets = $600,000

Value of Debt = 50% * Value of Assets
Value of Debt = 50% * $600,000
Value of Debt = $300,000

Interest Expense = 9% * Value of Debt
Interest Expense = 9% * $300,000
Interest Expense = $27,000

Net Income = (EBIT - Interest Expense) * (1 - tax)
Net Income = ($70,000 - $27,000) * (1 - 0.35)
Net Income = $27,950

ROE = Net Income / Value of Equity
ROE = $27,950 / $300,000
ROE = 9.32%

Answer d.

EPS = Net Income / Number of shares outstanding
ROE = $27,950 / 5,000
ROE = $5.59