Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate? A) Increasing financial leverage for a firm that has a negative operating margin will make the firm’s ROE less negative. B) Using financial leverage increases the volatility of ROE for a level of volatility in operating income. C) Increasing financial leverage increases both risk and potential return of existing bondholders. D) If a firm has a positive operating profit margin, using financial leverage will always increase ROE. Thanks for explaining your reasoning.
A. Increasing financial leverage with a negative profit margin will make a firms ROE MORE negative. B. Correct C. Bondholders don’t get an increase in return but an increase in leverage can increase the risk they face. D. This looks right, but I never like the word always in these questions. I would think if interest expense becomes too high ROE can decrease.
A. No…If you are losing money now, why increase your borrowing to lose more money. All else equal, ROE will be more negative. B. Yes. Increasing the leverage will have a “multiplying” effect on ROE. Throw one rock in the water, get a wave…throw a bigger one in…get a bigger wave. C. No. The potential return for bondholders, ie. coupon and yeild initially, is set. D. No. The interest payments could easily offset any increase in proportional income to equity holders, or decrease ROE. Just my quick thoughts on it. C seems like it may be wrong, and for that matter all of them. Look at the ROE formula broken down into the above mentioned parts and it should be clear.
Ahh Niblita you made me feel better now. I like how you think, as I hoped what I typed was correct.
I think it’s B. It’s explained in details in the CFAI text (with complete examples).
Indeed it’s B. I chose C stupidly as my brain read stockholders, which would have had an increase of both risk and return with an increase in leverage. Thanks for making it clear, I like to understand where my mind goes sometimes 
b d would looks like it’s ok BUT not for all positive margin roe increases. the money paid on debt needs to be less than what is earned on investing them to increase roe
Ruhi…could you give the page no. pls?
Take a look at page 126 -127 in corporate finance book on the state trade-off theory of capital structure.
not A,C,D hence B. Is there a direct way to reach to ans B? What’s the relation between FL (D/E) and ROE?
nicolargol Wrote: ------------------------------------------------------- > Which of the following statements regarding the > impact of financial leverage on a company’s net > income and return on equity (ROE) is most > accurate? > > A) Increasing financial leverage for a firm that > has a negative operating margin will make the > firm’s ROE less negative. > If operating margin is negative, the Net Income is likely to be negative (provided that non-operating operations doesn’t turn a profit greater than the loss from continuing operations). Increasing financial leverage for a firm that has a negative Net Income will make the firm’s ROE MORE negative. > B) Using financial leverage increases the > volatility of ROE for a level of volatility in > operating income. That sounds good. We have to assume that non-operating income doesn’t cancel ou the volatility in operating income. But that sounds like a good answer. > > C) Increasing financial leverage increases both > risk and potential return of existing bondholders. Nope. The potential return of existing bondholders is capped by the outflows (coupon payments) as described in the bond indenture (contract). Increasing financial leverage will however increase the risk of existing dondholders (likelyhood of bankruptcy) > > > D) If a firm has a positive operating profit > margin, using financial leverage will always > increase ROE. If a firm has a positive operating profit margin, using financial leverage will increase ROE PROVIDED THAT NON-OPERATING INCOME DOESN’T CAUSE NET INCOME TO BE NEGATIVE. In which case increasing financial leverage for a firm that has a negative Net Income will make the firm’s ROE MORE negative. > > > Thanks for explaining your reasoning. Answer B) is the most realistic. One has to make assumptions in order for each answer to hold true, but the assumtions to be made for B) are the most realistic
B by process of elimination
Dinesh, The good ole’ Dupont Model is the link between ROE and Financial leverage… ROE = NI/CE = NI/NS * NS/TA * TA/CE = Net Profit Margin * Total Asset Turnover * Financial Leverage Another way of looking at this: ROE = NI/CE = [EBIT - Int] [1-T] / CE = [EBIT - Int]/ TA * TA/CE * [1-T] = [EBIT/TA - Int/TA] * TA/CE * [1-t] = [EBIT/NS * NS/TA - Int/TA] * TA/CE * [1-t] = [Operating Profit Margin * Total Asset Turnover - Int Coverage] * Financial Leverage * [1-t] Thus getting to Extended Dupont
cpk123 Wrote: ------------------------------------------------------- > Dinesh, > > The good ole’ Dupont Model is the link between ROE > and Financial leverage… > > ROE = NI/CE > = NI/NS * NS/TA * TA/CE > = Net Profit Margin * Total Asset Turnover * > Financial Leverage > > Another way of looking at this: > ROE = NI/CE > = [1-T] / CE > = / TA * TA/CE * [1-T] > = * TA/CE * [1-t] > = * TA/CE * [1-t] > = * Financial Leverage * [1-t] > > Thus getting to Extended Dupont man cpk, I already owe you a hell lot for always helping me out in trouble times. I was just not able to connect the dot’s - probably because of mental block and stressed out work week.