306 Planning and Forecasting
Earnings before interest and taxes (EBIT) is thus $450,000 for both companies
in good times, and $50,000 for both in bad times. So far, this example illus-
trates an important lesson about leverage: Leverage has no impact on EBIT. If
we def ine retur n on assets (ROA)^1 as EBIT divided by assets, then leverage has
no impact on ROA.
If the pre-tax interest rate is 10%, however, then SomeDebt must pay
$50,000 of interest on its outstanding $500,000 of debt, regardless of whether
business is good or bad. NoDebt, of course, pays no interest. Because this is a
standard income statement, not a capital budgeting cash-f low computation, we
must account for interest. EBT (earnings before taxes, which is the same thing
as taxable income) for NoDebt is the same as its EBIT: $450,000 in good times
and $50,000 in bad times. For SomeDebt, however, EBT will be $50,000 less in
both states: $400,000 in good times and zero in bad times. Income tax is 40% of
EBT, so it must be $180,000 for NoDebt in good times, $20,000 for NoDebt
in bad times, $160,000 for SomeDebt in good times, and zero for SomeDebt in
bad times. Here we see the second important lesson about leverage: Leverage
reduces taxes.
Net earnings is EBT minus taxes. For NoDebt, net earnings is $270,000 in
good times and $30,000 in bad times. For SomeDebt, net earnings is $240,000
in good times and zero in bad times. Return on equity (ROE) equals net earn-
ings divided by equity. ROE is the profit earned by the equity investors as a
function of their equity investment. If, as in this example, there is no deprecia-
tion, no changes in net working capital, and no capital expenditures, then net
earnings would equal the cash f low received by equity investors, and ROE
would be that year ’s cash return on their equity investment. Notice that ROE
for NoDebt is 27% in good times and 3% in bad times. ROE for SomeDebt is
much more volatile: 48% in good times and 0% in bad times. This is the third
EXHIBIT 10.6 Performance of NoDebt Inc. and SomeDebt Inc.
NoDebt Inc. (thousands) SomeDebt Inc. (thousands)Net Earnings Good Times Bad Times Good Times Bad Times
Assets $1,000 $1,000 $1,000 $1,000
Debt 0 0 500 500
Equity $1,000 $1,000 $1, 500 $1, 500
Revenue $1,000 $1, 200 $1,000 $1, 200
COGS 500 100 500 100
SAG 50 50 50 50
EBIT 450 50 450 50
Interest 0 0 50 50
EBT 450 50 400 0
Tax (40%) 180 20 160 0
Net Earnings $1, 270 $1,0 30 $1, 240 $11,0 0
ROA 45.0% 5.0% 45.0% 5.0%
ROE 27.0% 3.0% 48.0% 0.0%