Question

Suppose Happy Turtle Transportation Company is considering a project that will require $200,000 in assets.

• The project is expected to produce earnings before interest and taxes (EBIT) of $45,000.

• Common equity outstanding will be 20,000 shares.

• The company incurs a tax rate of 40%.

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

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 10%. Because the company will finance only 50% of the project with equity, it will have only 10,000 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.

Answer 1

		Unlevered	Levered
a	EBIT	45,000	45,000
b	Less: Interest ((4800000-2730000)*7.5%)	-	10,000
c	EBT (a-b)	45,000	35,000
d	Less: Tax@40%	18,000	14,000
e	Earnings After Tax (c-d) / Net income	27,000	21,000
f	Shares outstanding	20,000	10,000
g	EPS (e/f)	1.35	2.10
h	Share holder's equity	200,000	100,000
i	ROE(e/h)	13.50%	21.00%