Question

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Consider the following case of Lost Pigeon Aviation: Suppose Lost Pigeon Aviation is considering a project that will require $200,000 in assets. • The project is expected to produce earnings before interest and taxes (EBIT) of $40,000. • Common equity outstanding will be 25,000 shares. • The company incurs a tax rate of 35%. If the project is financed using 100% equity capital, then Lost Pigeon's return on equity (ROE) on the project will be . In addition, Lost Pigeon's earnings per share (EPS) will Alternatively, Lost Pigeon Aviation'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 12%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. Lost Pigeon Aviation'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

1) 13.65% / 11.7% / 12.35% / 13%

2) $0.83/ $1.04/ $0.94/ $0.78/ $0.88

3) 19.11 & $1.39 / 20.02 & $1.53 / 17.29 & $1.31 / 18.20 & $1.46

4) increase / decrease

Answer 1

1)	EBIT	$        40,000
	Less:
	Tax @ 35%	$        14,000
	Net Income	$        26,000
	Return On Stockholders Equity = Net Income / Average Stockholders Equity
	= $26000/200000
	=13 %
2)	Earning Per Shares = Net Income/ Average Number Of Shares Outstanding
	= $26000/25000
	= $ 1.04
3)	EBIT	$        40,000
	Interest	$        12,000
	($100000*12%)
	Income Before Tax	$        28,000
	Less:
	Tax @ 35%	$          9,800
	Net Income	$        18,200
	Return On Stockholders Equity = Net Income / Average Stockholders Equity
	= $18200/100000
	=18.2 %
	Earning Per Shares = Net Income/ Average Number Of Shares Outstanding
	= $18200/12500
	= $ 1.46
4)	Increase