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Companies that use debt in their capital structure are said to be using financial leverage. Using leverage can increase shareholder returns, but leverage also increases the risk that shareholders bear.

Consider the following case:

Chilly Moose Fruit Producer is considering a project that will require $$650,000$ in assets. The project will be financed with $100\%$ equity. The company faces a tax rate of $30\%.$ Assuming that the project generates an expected EBIT $($earnings before interest and taxes$)$ of $$170,000,$ then Chilly Moose's anticipated ROE $($return on equity$)$ for the project will be:

$14\mathrm{.}65\%$

$18\mathrm{.}31\%$

$12\mathrm{.}82\%$

$11\mathrm{.}90\%$

In contrast, assume that the project's EBIT is only $$50,000.$ When calculating the tax effects, assume that the entire Chilly Moose Fruit Producer will earn a large, positive income this year. The resulting ROE will be $5,40\%{?}_g$rad.

Now consider the case of the Black Sheep Broadcasting Company:

Black Sheep Broadcasting Company is considering implementing a project that is identical to that being evaluated by Chilly Moose$-$although Black Sheep wants to finance the $$650,000\mathrm{.}00$ in additional assets using $50\%$ equity and $50\%$ debt capital. The interest rate on Black Sheep's new debt is expected to be $13\%,$ and the project is forecasted to generate an EBIT of $$170,000.$ As a result, the project is expected to generate a ROE of

Now assume that Black Sheep finances the same project with $50\%$ debt and $50\%$ equity capital, but expects it to generate an EBIT of only $$50,000.$ Further assume that the company as a whole will generate a large, positive income this year, such that any loss generated by the project $($with its resulting tax saving$)$ will be offset by the company's other $($positive$)$ income. Remember, the interest rate on Black Sheep's debt is $13\%.$ Under these conditions, it is reasonable to expect that Black Sheep will generate a ROE of:

$1\mathrm{.}96\%$

$1\mathrm{.}79\%$

$1\mathrm{.}62\%$

$1\mathrm{.}7\%$

Given the ROE$-$related findings above for both Chilly Moose and Black Sheep, answer the following question:

The use of financial leverage a firm's expected ROE, the probability of a large loss, and consequently the risk borne by the firm's stockholders.

The greater a firm's chance of bankruptcy, the its optimal debt ratio will be$.$ manager is more likely to use debt in an effort to boost profits.

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