Question

Western Gas & Electric 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 30%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $160,000?

15.9%

12.2%

11.2%

18.7%

Determine what the project’s ROE will be if its EBIT is –$50,000. When calculating the tax effects, assume that Western Gas & Electric Co. as a whole will have a large, positive income this year.

-4.6%

-5.8%

-6.4%

-4.9%

Western Gas & Electric Co. is also considering financing the project with 50% equity and 50% debt. The interest rate on the company’s debt will be 11%. What will be the project’s ROE if it produces an EBIT of $160,000?

34.0%

22.2%

29.6%

20.7%

What will be the project’s ROE if it produces an EBIT of –$50,000 and it finances 50% of the project with equity and 50% with debt? When calculating the tax effects, assume that Western Gas & Electric Co. as a whole will have a large, positive income this year.

-18.4%

-19.4%

-17.5%

-23.3%

The use of financial leverage INCREASE/DECREASE   the expected ROE, INCREASE/DECREASE   the probability of a large loss, and consequently INCREASE/DECREASE   the risk borne by stockholders. The greater the firm’s chance of bankruptcy, the HIGHER/LOWER its optimal debt ratio will be. AN AGGRESSIVE/CONSERVITIVE manager is more likely to use debt in an effort to boost profits.

Answer 1

1) The correct answer is option D i.e. 18.7%

ROE = Net Income / Shareholder's Equity

ROE =$112,000 / $600,000 = 18.7% (rounded off )

Net Income = EBIT - Tax

Net Income = $160,000 - ($160,000x30%) = $112,000

since, project is financed with 100% equity, assets = shareholder's equity =  $600,000

2) The correct answer is option b i.e. -5.8%

ROE = Net Income / Shareholder's Equity

ROE =-35000 / $600,000 = -5.8%

Net Income = EBIT - Tax

Net Income = $50000 - ($50000x30%) = -$35000

3) The correct answer is option C i.e. 29.6%

ROE = Net Income / Shareholder's Equity

ROE = $ 88900 / $ 300000 = 29.6%

Net Income = (EBIT - Interest) (1-taxrate)

Net Income = {$160000 - ($600000 x 50% x 11%)} (1-.30) =$88900

Shareholder's equity = $600,000 x 50% = $300,000

4) The correct answer is option b i.e. -19.4%

ROE = Net Income / Shareholder's Equity

ROE = -$58100 / $ 300000 = -19.4%

Net Income = (EBIT - Interest) (1-taxrate)

Net Income = {-$5000 - ($600000 x 50% x 11%)} (1-.30) = -$58100

Shareholder's equity = $600,000 x 50% = $300,000

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