1. Business and financial risk Aa Aa The impact of financial leverage on return
ID: 2763011 • Letter: 1
Question
1. Business and financial risk Aa Aa The impact of financial leverage on return on equity and earnings per share Consider this case: Suppose Sonaiya Development Group is considering a project that will require $350,000 in assets The project is expected to produce an EBIT (earnings before interest and taxes) of $40,000. · The project will be financed with 100% equity. Common equity outstanding will be 30,000 shares. · The company faces a tax rate of 35%. Using the preceding information, what will Sonaiya Development Group's return on equity (ROE) be for this project? o 7.43% O 5.94% o 6.69% O 8.17%Explanation / Answer
The Assets of the company =$ 350000
EBIT =$ 40000 Tax=35%
then the ROE =40000(1-t) => 40000*65%=$ 26000/350000=0.0743 or 7.43%
EPS = $ 26000 /30000(no of shares)=0.87
When there is 50% debt and 50% equity and the intrest on debt is 13%
so the burden of intrest is =$ 175000(50% debt i.e 350000/2) 175000*13%=22750
so the EBT is =40000-22750 =17250
so PAT = 17250(1-35%) 17250*65%=11212.50
NEW ROE=11212.50/175000(50% equity)=0.064 or 6.4%
NEW EPS =11212.50/15000(30000-15000)=0.75
When a firm uses debt ,this reduces the business risk placed on common stockholders.
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