The impact of financial leverage on return on equity and earnings per share Cons
ID: 2793963 • Letter: T
Question
The impact of financial leverage on return on equity and earnings per share Consider the following case of Green Rabbit Transportation Inc. Suppose Green Rabbit Transportation Inc. is considering a project that will require $250,000 in assets. The project is expected to produce earnings before interest and taxes (EBIT) of $60,000 Common equity outstanding will be 25,000 shares. · The company incurs a tax rate of 30%. 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 12%. Because the company will finance only 50% of the project with equity, it will have only 12,500 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 As a firm uses more debt in its capital structure, lenders will usually the interest rate chargedExplanation / Answer
EBIT = $60,000
Tax rate = 30%
If company financed total with equity then
Net Income = $60,000 × (1 - 30%)
= $42,000
Net income of company is $42,000.
Return on Equity = $42,000 / $250,000
= 16.80%
If company financed total with equity then return on equity will be 16.80%.
Earnings per share = $42,000 / 25,000
= $1.68
Earning per share is $1.68.
b.
Value of assets = $250,000
Value of debt = $125,000
Interest on debt = $125,000 × 12%
= $15,000
Now, Net income = ($60,000 - $15,000) × (1 - 30%)
= $45,000 × 70%
= $31,500
Net income in this case is $31,500.
Earning per share = $31,500 / 12,500
= $2.52
Earning per share in this case is $2.52.
Return on equity = $31,500 / $125,000
= 25.20%
If company finance 50% of its assets with debt the earning per share would be $2.52 and return on equity is 25.20%.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.