Now, to develop an example that can be presented to PizzaPalace’s management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000.
(1) Construct partial income statements, which start with EBIT, for the two firms.
(2) Now calculate ROE for both firms.
(3) What does this example illustrate about the impact of financial leverage on ROE?