Question

2. Business and financial risk The impact of financial leverage on return on equity and earnings per share Consider the following case of Lost Pigeon Aviation: Suppose Lost Pigeon Aviation is considering a project that will require $400,000 in assets. • The project is expected to produce earnings before interest and taxes (EBIT) of $40,000. • Common equity outstanding will be 10,000 shares. • The company incurs a tax rate of 35%. If the project is financed using 100% equity capital, then Lost Pigeon Aviation’s return on equity (ROE) on the project will be

Answer 1

Answer:

Return on equity = 6.5%

Explanation:

Return on equity (ROE) is the proportion of the equity capital that is earned as net profit. This is calculated using the formula below:

Return on equity = Profit after tax / equity value × 100

Profit after tax =( EBIT - interest)× (1-T)

Profit after tax =  (40,000 - 0)× (1-0.35) = 26,000

The total worth of equity would be equal to the cost of the assets . This is so because it project is financed entirely by equity.

Hence worth of equity = $400,000

Return on equity =  (26,000 /400,000) × 100 =6.5%

Return on equity = 6.5%