Question

The effect of financial leverage on ROE 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: Green Penguin Pencil Company 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 $150,000, then Green Penguin's anticipated ROE (return on equity) for the project will be:

A. 16.15%
B. 12.11%
C. 13.73%
D. 11.30%

Answer 1

The anticipated return on equity (ROE) for the Green Penguin Pencil Company's project, which will be financed with 100% equity and expects an EBIT of $150,000, is approximately 16.15% after accounting for a 30% tax rate.

Step-by-step explanation:

To calculate the expected return on equity (ROE) for Green Penguin Pencil Company, we first need to determine the net income the project will generate. Since Green Penguin uses 100% equity financing, there are no interest expenses, so we only have to account for taxes. The company has an expected EBIT of $150,000 and faces a 30% tax rate. This means that the taxes paid will be $150,000 multiplied by 30%, which equals to $45,000. Thus, the net income will be $150,000 - $45,000 = $105,000. The next step is to calculate the ROE, which is the net income divided by the shareholders' equity. The total investment in the project is $650,000, representing the shareholders' equity since it's 100% equity financed. Therefore, the ROE is calculated as $105,000/$650,000, resulting in an ROE of approximately 16.15%. Hence, the anticipated ROE for the project will be 16.15%. Given this information, the correct answer to the multiple-choice question is: A. 16.15%