Business and financial risk
The impact of financial leverage on return on equity and earnings per share
Consider the following case of Purple Panda Importers:
Suppose Purple Panda Importers is considering a project that will require $200,000 in assets.
• The project is expected to produce earnings before interest and taxes (EBIT) of $60,000.
• Common equity outstanding will be 10,000 shares.
• The company incurs a tax rate of 35%.
If the project is financed using 100% equity capital, then Purple Panda’s return on equity (ROE) on the project will be .?
a. 21.45%
b. 22.42%
c. 19.50%
d. 17.55%
In addition, Purple Panda’s earnings per share (EPS) will be ?
a. $4.29
b. $4.10
c. $3.70
d. $3.12
e. $3.90
Alternatively, Purple Panda Importers’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 5,000 shares outstanding. Purple Panda Importers’s ROE and the company’s EPS will be
a. 31.85 and $6.37, respectively
b. 36.63 and $7.01, respectively
c. 30.26 and $5.73, respectively
d. 38.22 and $7.33, respectively
if management decides to finance the project with 50% debt and 50% equity.
When a firm uses debt financing, the business risk exposure for the firm’s common shareholders will ?
a. increase
b. decrease