You are a very wealthy investor and would like to launch a project that you are sure will generate a lot of value in the future, while at the same time helping to save the planet. The investment requires S$20,000,000. While you have that money at your disposal, you have heard about the principle of leverage and how it could benefit you. However, you are also aware that it could backfire under certain circumstances, and you are therefore considering two financing options.

• The first option requires you to fund the entire investment in equity at $1 per share.
• The other option would consist in borrowing 60% of the needed amount at a rate of 3.5%, with the rest financed by equity at $1 per share.

(a) Establish the EBIT level such that the earnings per share of the investment is the same under both financing options, and the associated ROEs under both financing options. Assume the firm’s tax rate is 18.5%.

(b) If you were convinced that your first year would reach an EBIT of S$850,000, and that subsequent years would only see earnings improvement, what financing option would you chose? Use the principle of leverage to justify your decision.

Answer rating: 100% (QA)

To determine the EBIT level at which the earnings per share EPS is the same under both financing options we need to compare the EPS for each option Le... View the full answer