Question

Suppose Purple Panda Importers is considering a project that will require $400,000 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 $40,000. - 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 Purple Panda Importers's return on equity (ROE) on the project will be addition, Purple Panda's earnings per share (EPS) will be 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 12%. Because the company will finance only 50% of the project with equity, it will have only 15,000 shares outstanding. Purpl Panda Importers's ROE and the company's EPS will be if management decides to finance the project with 50% debt and 50% equity. Typically, using financial leverage will a project's expected ROE.

Answer 1

When Purple Panda Importers finances the project with 100% equity capital, the return on equity (ROE) and earnings per share (EPS) will be $1 per share. However, if the project is financed with 50% debt and 50% equity capital, the ROE and EPS will decrease to $0.80 per share.

Scenario 1: 100% Equity Financing

1. Earnings Before Interest and Taxes (EBIT): $40,000
2. Tax Rate: 25%
3. Net Income (EBT - Tax): $30,000
4. Return on Equity (ROE): Net Income / Common Equity - ROE = $30,000 / 30,000 shares = $1 per share
5. Earnings Per Share (EPS): Net Income / Number of Shares - EPS = $30,000 / 30,000 shares = $1 per share

Scenario 2: 50% Debt, 50% Equity Financing

1. Total Assets: $400,000 - 50% Debt = $400,000 * 0.50 = $200,000 - 50% Equity = $400,000 * 0.50 = $200,000
2. Interest Expense (Debt * Interest Rate): $200,000 * 12% = $24,000
3. Earnings Before Tax (EBT): EBIT - Interest Expense - EBT = $40,000 - $24,000 = $16,000
4. Net Income (EBT - Tax): $16,000 - (25% * $16,000) = $12,000
5. Return on Equity (ROE): Net Income / Common Equity - ROE = $12,000 / 15,000 shares = $0.80 per share
6. Earnings Per Share (EPS): Net Income / Number of Shares - EPS = $12,000 / 15,000 shares = $0.80 per share

Comparison:

• ROE: In Scenario 1 (100% equity financing), ROE is higher at $1 per share compared to Scenario 2, where ROE is $0.80 per share. This is because financial leverage (using debt) amplifies returns on equity when the project performs well.
• EPS: Similar to ROE, EPS is higher in Scenario 1 ($1 per share) compared to Scenario 2 ($0.80 per share).

Conclusion: Using financial leverage (50% debt, 50% equity) increases the project's expected ROE, as evidenced by the higher ROE and EPS in Scenario 1 compared to Scenario 2. However, it's important to note that financial leverage also increases the risk and volatility of returns, as interest payments on debt must be made regardless of the project's performance.

Answer 2

Using debt financing has lowered the project's expected ROE from 7.5% to 6% due to interest expenses reducing available net income for equity holders.

How to explain

Case 1: 100% Equity Financing

Earnings before interest and taxes (EBIT): $40,000

Interest expense: $0

Earnings before taxes (EBT): $40,000

Income taxes: $10,000 (EBT * 25%)

Net income: $30,000

Shares outstanding: 30,000

Return on equity (ROE): Net income / Shareholders' equity = $30,000 / ($400,000 * 1) = 7.5%

Earnings per share (EPS): Net income / Shares outstanding = $30,000 / 30,000 = $1

Case 2: 50% Debt and 50% Equity Financing

Debt financing: $200,000

Equity financing: $200,000

Shares outstanding: 15,000

Interest expense: $200,000 * 12% = $24,000

Earnings before taxes (EBT): $40,000

Interest expense: $24,000

Earnings before taxes (EBT): $16,000

Income taxes: $4,000 (EBT * 25%)

Net income: $12,000

Return on equity (ROE): Net income / Shareholders' equity = $12,000 / ($200,000 * 1) = 6%

Earnings per share (EPS): Net income / Shares outstanding = $12,000 / 15,000 = $0.8

Effect of Financial Leverage

Using debt financing has lowered the project's expected ROE from 7.5% to 6% due to interest expenses reducing available net income for equity holders.

Leverage usually boosts ROE if the project's return on assets (ROA) exceeds the cost of debt; otherwise, it decreases ROE.