Question

5. Business and financial risk

The impact of financial leverage on return on equity and earnings per share

Consider the following case of Happy Turtle Transportation Company:

Suppose Happy Turtle Transportation Company is considering a project that will require $350,000 in assets.

•	The project is expected to produce earnings before interest and taxes (EBIT) of $45,000.
•	Common equity outstanding will be 15,000 shares.
•	The company incurs a tax rate of 30%.

1. If the project is financed using 100% equity capital, then Happy Turtle’s return on equity (ROE) on the project will be what %? In addition, Happy Turtle’s earnings per share (EPS) will be?

2. Alternatively, Happy Turtle Transportation Company’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 11%. Because the company will finance only 50% of the project with equity, it will have only 7,500 shares outstanding. Happy Turtle Transportation Company’s ROE and the company’s EPS will be ? if management decides to finance the project with 50% debt and 50% equity.

3. When a firm uses debt financing, the business risk exposure for the firm’s common shareholders will increase or decrease?

Answer 1

A]	The ROE/EPS for the two alternatives are calculated in the table below:
		Plan I	Plan II
		100% Equity	50% Equity/ 50% Debt
	Equity	$         3,50,000	$        1,75,000
	Debt	$ -	$        1,75,000
	Number of shares	15000	7500
	EBIT	$            45,000	$            45,000
	Interest [350000*50%*11%]	$ -	$            19,250
	EBT	$            45,000	$            25,750
	Tax at 30%	$            13,500	$              7,725
	NI	$            31,500	$            18,025
	ROE [Ni/Equity]	9.00%	10.30%
	EPS [NI/Number of shares]	$ 2.10	$                2.40
B]	When debt is used the business risk does not increase for the common
	shareholders. It is the financial risk that increases, as debt brings in fixed
	costs of financing that have to be borne irrespective of the results.