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.