Consider the Following Leverage Scenarios: Leverage Scenarios (000s) If Under Certain Circumstances, Financial Leverage Enhances Performance Measured by

question 125

Multiple Choice

Consider the following leverage scenarios: Leverage Scenarios (000s)
$\begin{array}{llll}&\# 1 & \# 2 & \# 3 \\&0 \% \text { Debt } & 50 \% \text { Debt } & 80 \% \text { Deb }\\\text { Capital } & & & \\\text { Debt } & -\$ 1,000 & \$ 1,600 \\\text { Equity } & \$ 2,000 & 1,000 & 400 \\\text { Total capital } & 2,000 & \$ 2,000 & \$ 2,000 \\\text { Shares@ } \$ 10 &200,0007100,000&40,000\\\text { Revenue } & \$ 2,000 & \$ 2,000 & \$ 2,000 \\\text { Less costs/ expenses } & 1,800 & 1,800 & 1,800 \\\text { EBIT } & 200 & 200 & 200 \\\text { Interest expense }(10 \%) & - & 100 & 160 \\\text { EBT } & 200 & 100 & 40 \\\text { Taxes @ 40\% } & 80 & 40 & 16 \\\text { Earnings after tax } & \$ 120 & \$ 60 & \$ 24\\\text { ROE } &6\%&6\%&6\%\\\text { EPS } & \$.60&\$.60&\$.60\end{array}$ If under certain circumstances, financial leverage enhances performance measured by ROE and EPS, why does shifting from equity into debt have no effect in this case?

• A) The company hasn't repurchased enough shares of stock with borrowed money.
• B) The money the company is earning on its capital is exactly what it costs to borrow.
• C) ROCE is too high.
• D) ROCE is equal to the after tax cost of debt.

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Definitions:

Price

The amount of money or consideration exchanged for the ownership or use of a good or service.

Business

An organization or enterprising entity engaged in commercial, industrial, or professional activities, often structured to produce and sell goods and services for profit.

Present Value

Present value represents the current value of a future amount of money or series of cash flows, discounted at a certain rate of return.

Discount Rate

In finance, the rate used to discount future cash flows to their present value, essentially reflecting the time value of money and risk.