Companies that use debt in their capital structure are said to be using financia
ID: 2792847 • Letter: C
Question
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 $600,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 40%, what will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $140,000? O 10.5% O 14.7% O 14.0% O 9.8% 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. 0-66% 0-55% 0-58% -5.2%Explanation / Answer
1. 100% equity
Net income = EBIT * (1 - tax)
Net income = 140000 * (1 - 0.4)
Net income = 140000 * 0.6
Net income = $84,000
ROE = Net income/equity
ROE = 84000/600000 = 14%
If EBIT = -$55,000
Net income = -55000 * (1 - 0.4)
Net income = -$33,000
ROE = -33000/600000 = -5.5%
2. 50% debt and 50% equity
interest rate = 12%
Total capital = $600,000
Debt = $300,000
Equity = $300,000
interest charge = 300,000 * 12%
interest charge = $36,000
Net income = (EBIT - interest charge) * (1 - tax)
Net income = (140000 - 36000) * 0.6
Net income = 62,400
ROE = 62400/300000
ROE = 20.8%
If EBIT = -55,000
interest charge = 36000
Net income = (EBIT - interest charge) * (1 - tax)
Net income = (-55000 - 36000) * 0.6
Net income = -$54,600
ROE = -54600/300000
ROE = -18.2%
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