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:

1) Mammoth Pictures Inc. is a small company and is considering a project that will require $700,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 25%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $150,000?

16.07%

16.87%

13.66%

12.05%

2) Determine what the project’s ROE will be if its EBIT is –$55,000. When calculating the tax effects, assume that Mammoth Pictures Inc. as a whole will have a large, positive income this year.

-6.78%

-5.9%

-5.60%

-6.49%

3) Mammoth Pictures Inc. is also considering financing the project with 50% equity and 50% debt. The interest rate on the company’s debt will be 13%. What will be the project’s ROE if it produces an EBIT of $150,000?

19.03%

23.51%

22.39%

25.75%

4) What will be the project’s ROE if it produces an EBIT of –$55,000 and it finances 50% of the project with equity and 50% with debt? When calculating the tax effects, assume that Mammoth Pictures Inc. as a whole will have a large, positive income this year.

-23.69%

-26.92%

-25.85%

-21.54%

5) Allied Biscuit Co. currently is financed with 10% debt and 90% equity. However, its CFO has proposed that the firm issue new long-term debt and repurchase some of the firm’s common stock. Its advisers believe that the long-term debt would require a before-tax yield of 10%, while the firm’s basic earning power is 14%. The firm’s operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will increase the firm’s stock price. If Allied Biscuit Co. proceeds with the recapitalization, which of the following items are also likely to increase? Check all that apply.

Basic earning power (BEP)

Net income

Return on assets (ROA)

Cost of debt (rdrd)

Cost of equity (rsrs)

Answer 1

Q1) A) 16.07%

Explanation:

Value of Equity = 700,000

Net Income = (EBIT - Interest) * (1 - tax)
Net Income = (150,000 - 0) * (1 - 0.25)
Net Income = $112,500

Return on Equity = Net Income / Value of Equity
Return on Equity = 112,500 / 700,000
Return on Equity = 16.07%

Q2) B) -5.90%

Explanation:

Value of Equity = 700,000

Net Income = (EBIT - Interest) * (1 - tax)
Net Income = (-55,000 - 0) * (1 - 0.25)
Net Income = -41 250

Return on Equity = Net Income / Value of Equity
Return on Equity = - 41,250 / 700,000
Return on Equity = -5.90%

Q3) C) 22.39%

Explanation:

Value of Assets = 700,000

Value of Equity = 50% * Value of Assets
Value of Equity = 50% * 700,000
Value of Equity = 350,000

Value of Debt = 50% * Value of Assets
Value of Debt = 50% * 700,000
Value of Debt = 350,000

Interest = 13% * Value of Debt
Interest = 13% * 350,000
Interest = 45,500

EBIT = 150,000

Net Income = (EBIT - Interest) * (1 - tax)
Net Income = (150,000 - 45,500) * (1 - 0.25)
Net Income = 78,375

Return on Equity = Net Income / Value of Equity
Return on Equity = 78,375 / 350,000
Return on Equity = 22.39%

Q4) D) -21.54%

Explanation:

Value of Equity = 50% * Value of Assets
Value of Equity = 50% * 700,000
Value of Equity = 350,000

Value of Debt = 50% * Value of Assets
Value of Debt = 50% * 700,000
Value of Debt = 350,000

Interest = 13% * Value of Debt
Interest = 13% * 350,000
Interest = 45,500

EBIT = - 55,000

Net Income = (EBIT - Interest) * (1 - tax)
Net Income = (- 55,000 - 45,500) * (1 - 0.25)
Net Income = - 75,375

Return on Equity = Net Income / Value of Equity
Return on Equity = -75,375 / 350,000
Return on Equity = -21.54%