Assignment 13-Capital Structure and Leverage DueToday at 1159PM EST The impact o
ID: 2804374 • Letter: A
Question
Assignment 13-Capital Structure and Leverage DueToday at 1159PM EST The impact of financial leverage on return on equity and earnings per share Consider the following case of Green Rabbit Transportation Inc.: Suppose Green Rabbit Transportation Inc. is considering a project that will require $300,000 in assets . The project is expected to produce earnings before interest and taxes (EBIT) of $55,000. Common equity outstanding will be 20,000 shares. The company incurs a tax rate of 35%. If the project is financed using 100% equity capital, then Green Rabbit Transportation Inc.'s return on equity (ROE) on the project will be In addition, Green Rabbit's earnings per share (EPS) will be Alternatively, Green Rabbit Transportation 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 10,000 shares outstanding. Green Rabbit Transportation Inc.'s ROE and the company's EPS will be 50% debt and 50% equity. if management decides to finance the project with 8Explanation / Answer
Answer)
Total Asset = 300000
EBIT = 55,000
When the capital structure has 100% equity
So total equity = 300,000
net Income = EBIT - Interest - Taxes = 55000-0 - (55,000*35%) = 35750
ROE = Net Income / Total equity
ROE = 35750/300000 = 0.1191 OR 11.91%
EPS = Net Income / Total number of outstanding shares = 35750/20000 = 1.79
When the financing structure changes to 50% debt and 50% equity,
Net Income = EBIT - Interest - Taxes = 55000-(50%*300000*11%) - (taxes) = 55000-16500-5775 = 32725
EPS = 32725 / 10000 = 3.2725
ROE = Net Income / Total Equity = 32725 / 50%*300000 = 32725/150000 = 21.82%