Consider the following case of Happy Turtle Transportation Company: Suppose Happy Turtle Transportation Company is considering a project that will require $300,000 in assets.
The project is expected to produce earnings before interest and taxes (EBIT) of $55,000.
Common equity outstanding will be $30,000 shares.
The company incurs a tax rate of 40%.
1. If the project is financed using 100% equity capital, then Happy Turtle Transportation Company’s return on equity (ROE) on the project will be 11.55% / 10.45% / 13.20% / 11.00%. In addition, Happy Turtle’s earnings per share (EPS) will be$ 0.99 / $ 1.10 / $ 1.21 / $0.94 / $ 1.05.
2. Alternatively, Happy Turtle Transportation Company’s CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the company’s debt will be 13%. Because the company will finance only 50% of the project with equity, it will have only 15,000 shares outstanding. Happy Turtle Transportation Company’s ROE and the company’s EPS will be if the management decides to finance the project with 50% debt and 50% equity.
14.20% and $ 1.42, respectively
14.91% and $ 1.35, respectively
17.04% and $ 1.63, respectively
16.33% and $ 1.56, respectively
3. When a firm uses debt financing, the business risk exposure for the firm’s common shareholders will increase / decrease.