Question

A new business requires $100,000 investment. The project can either be entirely equity financed, or 50%of the investment can be funded by a bank loan at 12%. Assume no tax. EBIT is expected to be $15,000, but it could be as low as $5,000.

a)Calculate ROE for all 4 scenarios (unlevered low EBIT, unlevered high EBIT, levered low EBIT, unlevered high EBIT).

b)At what level of EBIT the shareholders receive the same return on equity regardless the percentage of debt financing? (note the answer for part b is not zero)

Answer 1

Unlevered:

Equity investment = $100,000

a)High EBIT = $15000

SInce no leverage =PAT = EBIT

ROE = $15000/$100,000 = 15%

b)Low EBIT = $5000

SInce no leverage =PAT = EBIT

ROE = $5000/$100,000 = 5%

Levered:

Equity investment = $50,000

a)High EBIT = $15000

PAT = EBIT -Interest = $15000- 12%*50,000 =$9,000

ROE = $9000/$100,000 = 9%

b)Low EBIT = $5000

PAT = EBIT -Interest = $5000- 12%*50,000 =-$1,000

ROE = -$1000/$100,000 = -1%

Note: Incase of any doubt, please do comment. I will get back to you. Thanks!!