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9. Business and financial risk The impact of financial leverage on return on equity and earnings...

9. Business and financial risk

The impact of financial leverage on return on equity and earnings per share

Consider the following case of Free Spirit Industries Inc.:

Suppose Free Spirit Industries Inc. is considering a project that will require $250,000 in assets.

• The company is small, so it is exempt from the interest deduction limitation under the new tax law.
• The project is expected to produce earnings before interest and taxes (EBIT) of $50,000.
• Common equity outstanding will be 30,000 shares.
• The company incurs a tax rate of 25%.

If the project is financed using 100% equity capital, then Free Spirit Industries Inc.’s return on equity (ROE) on the project will be   . In addition, Free Spirit’s earnings per share (EPS) will be   .

Alternatively, Free Spirit Industries Inc.’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 15,000 shares outstanding. Free Spirit Industries Inc.’s ROE and the company’s EPS will be   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   .

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