# ROE /Financial Leverage

Munn Industrial Components currently finances its operations with 100 percent equity, but is considering changing its target capital structure to 70 percent equity and 30 percent debt. Munn has a large asset base, a 20 percent operating profit margin, and the average interest rate on debt is expected to be 6.0 percent. If Munn makes the change to its capital structure and EBIT is unchanged, what is most likely the impact on Munn’s net income and return on equity (ROE) respectively? Impact on Net Income Impact on Return on Equity A) Decrease Decrease B) No Change Increase C) Decrease Increase D) No Change Decrease

A?

yeah thats what i thought. The answer is C and the logic given is: You should be able to figure out this question with logic without having to use calculations. The interest expense associated with using debt represents a fixed cost that reduces net income. However, the lower net income value is spread over a smaller base of equity capital, serving to increase the ROE. ------------------------------------------------------------------------------------------------ But if you think of the numerator effect here, then it should actually decrease. However from Dupont equation where ROE is directly proportional to leverage, all else equal an increase in leverage should increase the ROE. Now that is confusing and surely wont help on the exam. any thoughts?

reema, the only way ROE will increase when NI falls is if NI > equity, so the denominator effect will dominate. I haven’t done the calcs here and I’m not sure if this is the case with this problem, bu if so, it’s definitely unusual.

The large drop in equity will make ROE larger than the small interset expense you will incur due to the debt. So, a small drop in NI but a much larger increase in ROE. I picked C based on this reason.

I am actually surprised lola didn’t get this one

haha Dreary, I’m in a mad rush to finish a practice exam (the race against time has begun) and these days I sometimes post a few general comments without reading the questions thoroughly. I guess I should stop doing that. Nice work on your part though.

I picked C too and my reason was that Income decreases because of the interest expese but the financial leverage is 1.5 now instead of 1 so net income decreases but Roe increases

What you’re having to look at is the fact that you’re going to pretty much have the same net income (less what you now have to pay in interest on the debt which here is 6%) but the reason that the the ROE is going up considerably is that the Net Income is now only spread over 70% of what the original equity component was. That’s why you have to look out for companies with explosive growth in ROE as the company may be heavily financed in debt (read here Rogers for you Canadian folks) so the Net Income is only spread over a small equity financing.

good question. I’m glad I got it right

But be careful, the question has some qualifying conditions, namely “Munn has a large asset base, a 20 percent operating profit margin”, and the 70 to 30 D/E ratio. Changing any of these can change the answer!!