engage MrdTap . Cengage Lev × d, ng cengage.com/static/nb/uur dechtml?nbld-59329

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engage MrdTap . Cengage Lev × d, ng cengage.com/static/nb/uur dechtml?nbld-5932918 nt Nodeld 216270947&eiseN-9781305635975; &parent; d-2 MINDTAP Assignment 13-Capital Structure and Leverage e Due on Now 13 at 11 PM EST 3. The effect of financial leverage on ROE AaAa 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: Three waters Co. is considering a project that will require $700,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 35%, what wil be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $140,0007 9.8% 8.5% 13.0% Determine what the project's ROE will be if its EBIT is -$55,000. When calculating the tax effects, assume that Three Waters Co. as a whole will have a large, positive income this year. 9-5.9% 9-4.6% 9-5, 1% -5.4% Three waters Co. is also considering financing the project with SO% equity and 50% debt. The interest rate on the company's debt will be 13%, what will be the project's Roe if it produces an EBIT of $140,0007 14.1% 17.6% 20.2% 13.2% Type here to search

Explanation / Answer

1)    13.0% ,

return on equity = Net income / Total shareholder's equity

= EBIT (1 - tax) / Total shareholder's equity

= $140000 * (1 - 0.35) / $700000

= $91000 / $700000

= 13%

2) - 5.1% ,

Return on equity = EBIT (1 - tax) / Total shareholder's equity

= -$55000 * (1-0.35) / $700000

= -$55000 * 0.65 / $700000

= -$35750 / $700000

= -5.1%

3)    17.6% ,

    return on equity = Net income / Total shareholder's equity

=   $61425 / ($700000 * 50%)

=   $61425 / $350000

= 17.6%

  Note:-   EBIT = $140000

   less: interest(50% * $700000 * 13%) = $45500

EBT = $94500

   less: income tax = $33075  

   Net income = $61425

4)     -18.7% ,

    return on equity = Net income / Total shareholder's equity   

=    ($65325) / ($700000 * 50%)

=    ($65325) / $350000

= -18.7%

  Note:-   EBIT = (55000)

   less: interest(50% * $700000 * 13%) = $45500

EBT = ($100500)

   less: income tax = ($35175)  

   Net income = ($65325)

5) The use of financial leverage increasethe expected ROE , increase the probability of a large loss and consequently increase the risk borne by stockholders. The greater the firm's chances of bankruptcy, the lower its optimal debt ratio will be an aggressive manager is more likely to use debt in an effort to boost profits.

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