The Effect of Leverage on Earnings

Download the Module 04_Leverage Problem. Excel template and complete the included problem.
The Effect of Leverage on Firm Earnings

A firm needs $100 to start and has the following expectations:

Sales $200
Expenses $185
Tax rate 33% of earnings

a. What are earnings if the firm owners invest the $100 thus utilizing no financial leverage? Tax and net earnings values should be rounded to 2 decimal places.

b. If the firm borrows (utilizes financial leverage) $40 of the $100 at an interest rate of 10%, what are the firm’s net earnings? Tax and net earnings values should
be rounded to 2 decimal places.

c. What is the return on equity when financial leverage is and is not utilized? Why do the returns differ? ROE results should be shown with 2 decimal places.

d. If expenses increase to $194, what will be the new return on equity values for each scenario? ROE results should be shown with 2 decimal places.

e. Did the returns decline more when financial leverage was or was not utilized?

f. How does the use of financial leverage effect a firm’s earnings? When is using financial leverage beneficial? When is it disadvantageous?