Question

Develop an example which can be presented to your management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm K, which uses no debt financing, and Firm L, which uses $50,000 of 6 percent debt. Both firms have $150,000 in assets, a 30 percent tax rate, and an expected EBIT of $20,000.

a. Construct partial income statements, which start with EBIT, for the two firms.

b. Now calculate ROE for both firms.

c. What does this example illustrate about the impact of financial leverage on ROE?

Answer 1

• Requirement a

Income Statements – Partial

	Firm K	Firm L
EBIT	$           20,000.00	$          20,000.00
(-) Interest expense		$            3,000.00
EBT	$           20,000.00	$          17,000.00
(-) Income tax expense 30%	$             6,000.00	$            5,100.00
Net Income	$           14,000.00	$          11,900.00

• Requirement ‘b’

Working		Firm K	Firm L
A	Net Income	$           14,000.00	$          11,900.00
B	Assets	$         150,000.00	$        150,000.00
C = (A/B) x 100	Return on Equity	9.33%	7.93%

• Requirement ‘c’

This illustrate that the more financial leverage or the debt the company has, the ROE will be LOWER.

Having debts saves some amount of Income taxes, as Interest is deductible.

However, Net Income gets reduced by the amount of Interest expense.