ROE = ni/equity. so more debt = higher interest exp so lower net income and assets go up but liabilities go up by the same amount so they cancel each other out and really the equation ends up lower ni (due to higher interest exp) / equity that is less by however much the higher interest charge is… all else equal ratio ROE should go down, i think
If our ROA is higher than after tax cost of debt then higher debt will increase ROE, if this is not the case (ROA
Milos Wrote: ------------------------------------------------------- > If our ROA is higher than after tax cost of debt > then higher debt will increase ROE, if this is not > the case (ROA will decrease. This particularly means that if we > borrow at rate k, we need to have a return on our > assets that is greater than after tax cost of > debt. In this case, we will earn excess return for > our shareholders, i.e. higher ROE. My 0.02 bucks > > Milos As follow up your idea discussion, i see that the way Stalla explained ROE increasing by given the equation ROE = NI/Sales * Sales/ Assets * Assets/Equity is not completely persuasive in some cases. I don’t agree with Tony2 that ROE should be down due to hight interest exp end up in NI. Because asset rise may lead to increase in sales growth faster than expense. The problem i am still confusing at this moment is about the relationship between ROA and the cost of debt. Is there anything sure that ROA alway greater than cost of debt then bring higher ROE. Make it clear for me. Thank you!
In ROE: NI/Sales , the profit margin, is influenced by the level of competition in a specific industry Sales/Assets, asset turnover is affected by the management’s efficiency Assets/Equity, or (L+E)/E = 1+L/E, taking more debt makes this ratio going up more than if debt has not increased , makes ROE go up, assuming management’s efficiency, at the level of competition specific in the industry Compared with a company with smaller debt, probably the ROE would not grow as much, but it still grows.
ni/sales agreed are influenced by competition but assuming sales are unchanged, the higher interest cost should lower the NPM and sales/assets is mgmt efficiency but asset levels will be higher (increase in liab/debt=increase in asset account) so this will lower the asset turnover, and Assets/equity will go up as equity should be lower with less profits retained and higher debt levels… my question then becomes would lower NPM, Lower A/T and higher leverage increase the ROE, i’d be inclined to think no. suggestions?
roe goes up. Firms typically take on debt for productive reasons (acquiring assets). Assuming that the corporate finance department considered the asset purchase and determined it to be npv positive, this asset will produce returns greater than the cost of debt, therefore increasing net income. The effect is to lift income / equity, because the disparity between asset returns and financing costs flows to the equity holders - this is the nature of leverage. Of course, if the corporate finance department was wrong, and the asset doesn’t produce, then you just end up with net income lower by the debt payment. I would expect the question to point out that the project is a failure, otherwise adding leverage increases roe