3. The effect of financial leverage on ROE

Companies that use debt in their capital structure are said tobe using financial leverage. Using leverage can increaseshareholder returns, but leverage also increases the risk thatshareholders bear.

Consider the following case:

Water and Power Co. is a small company and is considering aproject that will require $500,000 in assets. The project will befinanced with 100% equity. The company faces a tax rate of 25%.What will be the ROE (return on equity) for this project if itproduces an EBIT (earnings before interest and taxes) of$140,000?

23.10%

21.00%

15.75%

22.05%

Determine what the project’s ROE will be if its EBIT is–$40,000. When calculating the tax effects, assume that Water andPower Co. as a whole will have a large, positive income thisyear.

-6.0%

-7.20%

-6.90%

-5.70%

Water and Power Co. is also considering financing the projectwith 50% equity and 50% debt. The interest rate on the company’sdebt will be 13%. What will be the project’s ROE if it produces anEBIT of $140,000?

33.86%

32.25%

35.48%

27.41%

What will be the project’s ROE if it produces an EBIT of–$40,000 and it finances 50% of the project with equity and 50%with debt? When calculating the tax effects, assume that Water andPower Co. as a whole will have a large, positive income thisyear.

-28.27%

-27.19%

-23.92%

-21.75%

The use of financial leverage _______ theexpected ROE, _________ the probability of a largeloss, and consequently __________ the risk borneby stockholders. The greater the firm’s chance of bankruptcy,the__________    its optimal debt ratiowill be.___________    manager is morelikely to use debt in an effort to boost profits.