Consider the following case of Green Rabbit Transportation Inc.: Suppose Green R

Question

Consider the following case of Green Rabbit Transportation Inc.: Suppose Green Rabbit Transportation Inc. is considering a project that will require $350,000 in assets. The project is expected to produce earnings before interest and taxes (EBIT) of $50,000. Common equity outstanding will be 30,000 shares The company incurs a tax rate of 40%. If the project is financed using 100% equity capital, then Green Rabbit Transportation Inc.'s return on equity (ROE) on the project will be . In addition, Green Rabbit's earnings per share (EPS) will be Alternatively, Green Rabbit Transportation Inc.'s CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the company's debt will be 11%. Because the company will finance only 50% of the project with equity, it will have only 15,000 shares outstanding. Green Rabbit Transportation Inc.'s ROE and the company's EPS will be 50% debt and 50% equity. if management decides to finance the project with Typically, the use of financial leverage will make the probability distribution of RoI

Explanation / Answer

Invetsment required = 350,000
Company tax rate = 40%


if the project is financed with 100% equity there is no debt and thus no interest expense.
And thus Net income = EBIT*(1-Tax)
=50,000*(1-0.4)
=30000
Thus,
Return on equity = Net income / Equity = 30,000/350000 = 0.0857 = 8.57%
and with 30,000 shares outstanding, EPS = net income / no. of shares = 30,000/30,000 = $1


Now if the company decides to have 50% of debt financing in the total investment of 350,000
the interest expense will be 11% of 350,000/2 = 0.11*175000 = 19250
With EBIT given of 50,000
PBT = EBIT-Interest = 50,000-19250 = 30750
Net income = PBT*(1-Tax) = 30750*(1-0.4) = 18450
Thus,
Return on equity = Net income / Equity = 18450/175000 = 0.1054 = 10.54%
and with 30,000 shares outstanding, EPS = net income / no. of shares = 18450/15,000 = $1.23


The ROIC = EBIT / total invested capital = 50000/350000 = 0.1429 = 14.29%

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