Consider the following case Suppose Free Spirit Industries I

Consider the following case:

Suppose Free Spirit Industries Inc. is considering a project that will require $600,000 in total assets. The project is expected to produce an EBIT (earnings before interest and taxes) of $60,000, and will be financed with 100% equity. The company has a 35% tax rate and has 25,000 shares of common stock outstanding.

The return on equity (ROE) on Free Spirit’s project will be (5.2%, 6.18%, 6.5%, 7.8%) .

If the project is financed with 100% equity, the Free Spirit’s earnings per share (EPS) will be ($1.09, $1.33, $1.56, $1.72)   .

Free Spirit’s CFO is also considering financing this project with 50% debt and 50% equity. The interest rate on the company’s debt is expected to be 5%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. If the company decides to finance the project with 50% debt and 50% equity, the project\'s ROE will be (7.31%, 9.75%, 10.24%, 12.19%)   .

Free Spirit’s EPS will be ($1.87, $2.22, $2.34, $2.81)   if it finances this project with 50% equity and 50% debt.

Typically, the use of financial leverage will make the probability distribution of ROIC (Flatter, Stepper) .

Solution

Return on Equity = 60,000*0.65/600,000 = 6.5%

EPS = 60,000*0.65/25,000 = 1.56

return on equity = (60,000 - 0.05*0.5*600,000)*0.65/300,000 = 9.75%

EPS = (60,000 - 0.05*0.5*600,000)*0.65/25,000 = 2.34

flatter