Question

1.Ethics issues: How could a project manager adjust the cost of capital (i.e., appropriate discount rate) to increase the likelihood of having his/her project accepted? Is this ethical or financially sound?

2. Explain the effect of leverage on EPS and ROE.

3 .What is the break-even EBIT, and how do we compute it?

Answer 1

1. It is not ethically sound to do so, managers should project a true and fair picture of risk to the investors and not financially sound as well, as investing in high risk project can result in negative NPV and destruction of wealth of the investor.

A manager could assume that the project is less risky than the typical firm project and therefore apply a lower discount rate, which would increase the NPV. So, sensitivity analysis of projects has become increasingly important.

2. ROE = net income/ equity

As, the leverage of the company increases, it's equity investment decreases which leads to a rise in the ROE.

equity = assets - liabilities , with higher debt, equity decreases.

EPS also increases as the financial leverage increases, as the number of shares outstanding decreases which results in an increase in the EPS as EPS = NET INCOME/NO OF SHARES OUTSTANDING. With the use of more debt, fixed costs are incurred and not the higher costs that is involved with equity funds.

3.The break even EBIT is to find that level of EBIT where the EPS does not change.

EBIT Breakeven is calculated by finding the point where alternative financing plans are equal according to the following formula:

(EBIT - Interest ) x (1.0 - TR) / Equity number of shares after implementing financing plan. Assuming that the preference dividend is zero.

EBIT-EPS Analysis can help find the right capital mix for high returns and low costs of capital. You want to find the right plan that helps maximise EPS, but still manage risks within an acceptable range