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equal mix of debt and equity, its debt must be worth $500,000, and its equity must also be worth
$500,000. Aside from capital structure—that is, the mix of debt and equity used to finance the
companies—the two firms are identical. In good times, both companies make $1 million in sales. In
bad times, sales fall to $200,000. Cost of goods sold is always 50% of sales. Selling, administrative,
and general expenses are a constant $50,000. For simplicity we assume there is no depreciation.
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 illustrates an important lesson about leverage:
Leverage has no impact on EBIT. If we define return on assets (ROA) as EBIT divided by assets,
leverage has no impact on ROA. 1
Exhibit 6.6 Performance of NoDebt Inc. and SomeDebt Inc.
If the pretax 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 flow
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 earnings divided by equity. ROE is the profits earned by the equity investors
as a function of their equity investment. If, as in this example, there is no depreciation, no changes in
net working capital, and no capital expenditures, then net earnings would equal the cash flow 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 and most important lesson to be
learned from this example: For the equity investors, leverage makes the good times better and the bad
times worse. One student of mine, upon hearing this, exclaimed, “Leverage is a lot like beer!”