Ch 16: Assignment - Capital Structure Decisions 5. 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: Purple Panda Products Inc. is considering a project that will require $700,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 35%. Assuming that the project generates an expected EBIT (earnings before interest and taxes) of $140,000, then Purple Panda's anticipated ROE (return on equity) for the project will be: 13.00% 13.65% 14.30% 9.10% In contrast, assume that the project's EBIT is only $45,000. When calculating the tax effects, assume that the entire Purple Panda Products Inc. will earn a large, positive income this year. The resulting ROE will be Now consider the case of the Purple Whale Foodstuffs Inc.: Purple Whale Foodstuffs Inc. is considering implementing a project that is identical to that being evaluated by Purple Panda-although Purple Whale wants to finance the $700,000.00 in additional assets using 50% equity and 50% debt capital. The interest rate on Purple Whale's new debt is expected to be 12%, and the project is forecasted to generate an EBIT of $140,000. As a result, the project is expected to generate a ROE of Now assume that Purple Whale finances the same project with 50% debt and 50% equity capital, but expects it to generate an EBIT of only $45,000. Further assume that the company as a whole will generate a large, positive income this year, such that any loss generated by the project (with its resulting tax saving) will be offset by the company's other (positive) income. Remember, the interest rate on Purple Whale's debt is 12%. Under these conditions, it is reasonable to expect that Purple Whale will generate a ROE of: O 0.75% 0.63% 0.6% 0.78%