Due on Nov 15 at 11:59 PM CST Attempts: 6 Average: 6/9 3. The effect of financia

Question

Due on Nov 15 at 11:59 PM CST Attempts: 6 Average: 6/9 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: Sombra Corp. is considering a project that will require $600,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 35%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $150,0007 11.4% 16.3% 13.9% Determine what the project's ROE will be if its EBIT is-$45,000. When calculating the tax effects, assume that Sombra Corp. as a whole will have a large, positive income this year -4.9% -3.9% O-S496

Explanation / Answer

a) ROE = EBIT x (1 - tax rate) / Investment = 150,000 x (1 - 35%) / 600,000 = 16.3%

b) ROE = EBIT x (1 - tax rate) / Investment = -45,000 x (1 - 35%) / 600,000 = -4.9%

c) Debt = 50% x 600,000 = 300,000, Interest = 300,000 x 13% = 39,000, Equity = 50% x 600,000 = 300,000

Net Profit = (EBIT - Interest) x (1 - tax) = (150,000 - 39,000) x (1 - 35%) = 72,150

ROE = Net Profit / Equity = 72,150 / 300,000 = 24.1%

d) Net Profit = (-45,000 - 39,000) x (1 - 35%) = - 54,600

ROE = -54,600 / 300,000 = -18.2%

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