Consider the following case of Free Spirit Industries Inc : Suppose Free Spirit Industries Inc. is considering a project that will require $400,000 in assets:

• The company is small, so it is exempt from the interest deduction limitation under the new tax law.
• The project is expected to produce earnings before interest and taxes (EBIT) of $45,000.
• Common equity outstanding will be 10,000 shares.
• The company incurs a tax rate of 25%."

If the project is financed using 100% equity capital, then Free Spirit Industries Inc.'s return on equity (ROE) on the project will be. In addition, Free Spirit's earnings per share (EPs) will be

Alternatively, Free Spirit Industries Inc.'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 12%. Because the company will finance only 50% of the project with equity, it will have only 12, 500 shares outstanding. Free Spirit Industries Inc.'s ROE and the company's EPS will be if management decides to finance the project with 50% debt and 50% equity.

Typically, the use of financial average will make the probability distribution of ROIC:

Return on equity (ROE) on the project will be 8.43%. In addition, Free Spirit's earnings per share (EPs) will be $3.375 per share

ROE and the company's EPS will be 7.875% if management decides to finance the project with 50% debt and 50% equity.

The use of financial average will make the probability distribution of ROIC $4.5

Explanation:

Calculation of When the company financed with 100% equity

Using this formula

ROE = (EBIT – Interest)(1-Tax Rate)/Equity

Let plug in the formula

When financed with 100% equity,

ROE = 45,000(1-25%)/400,000

ROE=45,000(0.75)/400,000

ROE=33,750/400,000

ROE=8.43

Calculation for the Free Spirit's earnings per share (EPs)

EPS = (45,000)(1-25%)/10,000

EPS=45,000*0.75/10,000

EPS=33,750/10,000

= $3.375 per share

Calculation of When the company financed with 50% Debt

50%×400,000=200,00

ROE = (45,000 – 200,000*12%)(1-25%)/200,000

ROE=21,000×0.75/200,000

ROE=15,750/200,000

ROE=

= 7.875%

EPS = Net Income/Outstanding shares

EPS=45,000/10,000

EPS.=4.5 per share

Hence,7.875 % and $4.5 respectively

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