Can someone explain the relationship between DFL and ROE?
As far as I understand, DFL increases as usage of debt increases. Using more debt will lead to a higher interest expense therefore Net Income will decrease. A = L + E. Since L increased, E should decrease to maintain the balance.
If Net Income decreased and Equity decreased as well, does the ROE ratio increase or decrease?
What I meant to say is that if you have in one scenario 100% equity financing and in an other scenario 50% equity and 50% debt financing. Is the ROE in the second scenario higher or lower?
In the second scenario ROE will be lower.
Higher debt > higher interest expense > higher DFL > lower net income > lower ROE.
Taking more debt does not reduce equity.
Check the example here:
It is completely the opposite
Ok, I see. Be careful with this investopedia example. In this example you are assuming an re-engineered capital structure, so the analysis is totally different what I exposed previously.
Look, if you assume the same equity amount (50 million) but more debt, the result is how what I said.
Investopedia is explaining how debt into the capital structure is way more profitable (more ROE) just bacause you exchanging 25million equity with 25 million debt. Obviously this will enhance ROE.
If you want to analyze the pure impact of a higher DFL you must not move equity. In this case a higher DFL gives you lower ROE.
Look at the first chart. You have a DFL of 1.00 right? (no interest expense) and 50MM equity: ROE = 15.6%
In the second chart you have a DFL of 1.1429 and 25MM equity so ROE = 27.3%, but assume 50MM equity, now ROE is 13.65%
We see now 15.6 > 13.65 because a DLF is 1 < 1.1429
Summing up, a higher DFL = lower ROE
Thanks a lot. was very helpful
Glad to help!
Well, a little misunderstanding there.
An increase in financial leverage means more debt was used.
The implication of debt usage is interest expense, and thus, this interest expense will reduce Net Income (only Net Income, and not ROE) and lead to an increase in ROE.
Thus an increased Leverage will lead to an increase in ROE and a reduction in NET INCOME.
Dont have time to do the calculation, but you can find this in the corriculum or Schweser Note.
Cheers.
I think you confusing scenarios. I see when you say “more leverage” you mean a higher debt but lower equity, which won’t necessarily happen (Do not confuse % with dollar amounts). I mean, when you issue debt, your equity is unchanged, or does it drop? No, right?
Equity level is done (in dollars), is the capital given from the shareholders, and debt is rised to get an optimal capital structure.
So do not move all variables at once, only move the correct variables: debt, interest expense and as a result, net income.
You said more debt rises interest expense and reduces net income, and since Equity is UNCHANGED, the ROE will fall. (ROE = net income / average equity)
I’m aware that debt must enchance ROE, but not from a drop in Equity as you say, it comes from higher sales or income. Why? Remeber A = D + E, equity is given (constant this time), and we rise debt, so total assets (A) will rise. A higher level of assets MUST enhance income, thats why we issue debt in first instance. So income growth in a given rate must rise ROE even if your DFL is higher. But in real life, there is not always success, maybe we issue debt and just expenses rise… we lose.
You cannot rise debt indefinitely, your financing risk is intolerable, so you will need to rise more equity, changing your ROE to a lower level. This forces makes ROE, ROA to change.
Regards.
This very simple as there is a very straighforward relationship:
As long as the interest rate on the addtional debt is below the ROA (NI/Total Assets) an increase in leverage will always increase ROE (NI/Equity). Once the interest rate on the additional debt becomes greater than the ROA increasing leverage will decrease ROE. This effect is known as the leverage effect.
Just try to make an example with simple numbers so that it becomes clear.
Best,
Oscar