fm16 14 - stock is riskier if the firm uses debt • At the...

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Mini Case: 16 - 14 c. 2. Now calculate roe for both firms. Answer: Firm U Firm L BEP 15.0% 15.0% ROI 9.0% 11.4% ROE 9.0% 10.8% TIE 2.5 × c. 3. What does this example illustrate about the impact of financial leverage on ROE? Answer: Conclusions from the analysis: The firm’s basic earning power, BEP = EBIT/total assets, is unaffected by financial leverage. Firm L has the higher expected ROI because of the tax savings effect: o ROI U = 9.0%. o ROI L = 11.4%. Firm L has the higher expected ROE: o ROE U = 9.0%. o ROE L = 10.8%. Therefore, the use of financial leverage has increased the expected profitability to shareholders. The higher roe results in part from the tax savings and also because the
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Unformatted text preview: stock is riskier if the firm uses debt. • At the expected level of EBIT, ROE L > ROE U . • The use of debt will increase roe only if ROA exceeds the after-tax cost of debt. Here ROA = unleveraged roe = 9.0% > r d (1 - t) = 12%(0.6) = 7.2%, so the use of debt raises roe. • Finally, note that the TIE ratio is huge (undefined, or infinitely large) if no debt is used, but it is relatively low if 50 percent debt is used. The expected tie would be larger than 2.5 × if less debt were used, but smaller if leverage were increased....
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