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.
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
c)High EBIT = $15000
PAT = EBIT -Interest = $15000- 12%*50,000 =$9,000
ROE = $9000/$100,000 = 9%
d)Low EBIT = $5000
PAT = EBIT -Interest = $5000- 12%*50,000 =-$1,000
ROE = -$1000/$100,000 = -1%
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