Consider the following case of Free Spirit Industries Inc. Suppose Free Spirit I

Question

Consider the following case of Free Spirit Industries Inc. Suppose Free Spirit Industries Inc. is considering a project that will require $300,000 in assets. The project is expected to produce earnings before interest and taxes (EBIT) of $45,000. Common equity outstanding will be 15,000 shares. · The company incurs a tax rate of 35%. If the project is financed using 100% equity capital, then Free Spirit Industries Inc's return on equity (ROE) on the project will be In addition, Free Spirit's earnings per share (EPS) will be Alternatively, Free Spirit Industries 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 7,500 shares outstanding. Free Spirit Industries Inc.'s ROE and the company's EPS will be debt and 50% equity. if management decides to finance the project with 50% When a firm uses debt financing, the business risk exposure for the firm's common shareholders will

Explanation / Answer

1
As no debt so interest is zero and hence
Net Income=EBIT*(1-tax rate)=45000*(1-35%)=29250
RoE=Net Income/Equity=29250/300000=9.75%
EPS=Net Income/Number of Shares=29250/15000=1.95

2
Debt=50%*300000=150000
Interest=Debt*Interest rate=150000*11%=16500
Net Income=(EBIT-Interest)*(1-tax rate)=(45000-16500)*(1-35%)=18525
RoE=18525/150000=12.35%
EPS=18525/7500=2.47

When a firm uses debt financing, the business risk exposure for the firm's common shareholders will increase

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