Companies that use debt in their capital structure are said

Companies that use debt in their capital structure are said to be using financial leverage. Using leverage can increase sharehalder returns, but leverage also increases the risk that shareholders bear. Consider the following case: Green Moose Industries is considering a project that will require $550,000 in total assets. The project will be financed with 100% equity, and the company incurs a tax rate of 30%. Assuming that Green Moose\'s project will earn a an EBIT of?140,000, the project will generate an ROE (return on equity) of _17.82%%Y Now assume that the project will generate an EBIT of $-55,000. Assurning that Green Moase, as a whole, will realize a large, positive income this year and the pro ect will continue to be financed with 100% equity funding the p ects ROE l be 7.00% .(Hint: The project will incur a tax liability even if it realizes a pre-tax loss. This liability may be offset by tax liabilities produced by other prajects and other parts of the company.) Green Moose is also considering financing the project with 50% equity and 50% debt. The interest rate on the company\'s debt will be 5.00%. The project\'s ROE-assuming it produces an EBIT of $140,000-will be 22.50% What will be the project\'s ROE if it produces an EBIT of $-55,000 the tax effects, assume that Green Moose as a whole will have a lal 24.11% e income this year and that any borrowed funds will incur an interest rate of 5.00%. s 50% of the project with equity and 50% with debt? when calculating 30. 53% -27.12% 32.14% 17.50% 16.62% 15. 75% The use of financial leverage risk borne by stockholders. The greater the firm\'s chance of bankruptcy, the is more likely to use debt in an effort to boost prafits. the expected ROE, the probability or a large loss, and consequently 7 the its optimal debt ratio will be. manager Consider this case: Globo-Chem Company currently has a capital structure consisting of 35% debt and 65% equity. However, Gil 1.07-m Company\'s CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 2.5%, the market ri Globo-Chem Company\'s beta is 1.15 n is 8%, and 0.80 0.76 D.89 If the firm\'s tax rate is 45%, what will be the beta of an all-equity firm if its operations were exactly the same General Forge and Foundry Co, currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm\'s unlevered beta is 1.08, and its cost of equity is 13.72%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 13.72%. The risk-free rate of interest (rRF } is 4%, and the market risk premium (RP) is 9%. General Forge and Foundry Co.\'s m@rginal tax rate is 30%. General Forge and Foundry Co, is cxamining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table. Before-Tax Cost Cost of WACC 13.72 13.48 D/A Ratio E/A Ratio D/E Ratio Bond Rating of Debt ( Levered Beta (b) Equity (r) 0.0 0.2 0.4 0.6 0.8 1.0 0.8 0.6 0.4 0.2 0.00 0.25 0.67 1.50 13.72 15.43 18.22 1.08 8.10 8.50 10.90 13.90 1.27 1.58 2.21 4.10 8e 14.13 4.00 40.90 Grade It Now Save & Continue Continue without saving

Solution

RoE=(EBIT-Interest)*(1-tax rate)/(asssets*percentage of equity)

1.

=140000*(1-30%)/550000=17.82%

2.

=-55000*(1-30%)/550000=7%

3.

=(140000-550000*0.5*5%)*(1-30%)/(550000*0.5)=32.14%

4.

=(-55000-550000*0.5*5%)*(1-30%)/(550000*0.5)=-17.5%

5.

increases, increases, increases, lower, aggressive

6.

beta unlevered=levered beta/(1+(1-tax rate)*debt/equity)=1.15/(1+(1-45%)*0.35/0.65)=0.88724

7.

beta levered=unlevered beta*(1+(1-tax rate)*(D/A)/(E/A))=1.08*(1+(1-30%)*0.2/0.8)=1.27

8.

WACC=cost of equity*proportion of equity+cost of debt*(1-tax rate)*proportion of debt=18.22%*0.6+8.5%*(1-30%)*0.4=13.312%

9.

WACC=cost of equity*proportion of equity+cost of debt*(1-tax rate)*proportion of debt

14.13%=cost of equity*0.4+10.90%*(1-30%)*0.6

=>cost of equity=23.88%

10.

D/E=(D/A)/(E/A)=0.8/0.2=4

WACC=0.8*13.90%*(1-30%)+0.2*40.90%=15.964%