Question

A firm has a tax burden ratio of 0.8, a leverage ratio of 2, an interest burden of 0.6, and a return on sales of 8%. The firm generates $3 in sales per dollar of assets.

-What is the firm's ROE?

- What is the firm's compound leverage factor?

- Does the company increase its ROE by using loans? How one can see that?

Answer 1

Answer-

ROE = ( net income / sales ) x ( sales / assets ) x ( assets / equity )

ROE = 8 % x  ( $ 3 / $1 ) x 2 ( return on sales = net income / sales, Leverage = assets / equity)
ROE = 0.08 x 3 x 2
ROE= 0.48
ROE = 48 %

Compound leverage factor = Interest burden x leverage = 0.6 x 2 = 1.2

The company can increase the ROE by loans as loans are debt and it increases the leverage which is presently = 2.0. By raising loans the debt increases as leverage = assets / equity increases as assets = liabilities or debt + equity. so by taking loans or debt the numerator of assets / equity increases as assets increases whereas equity remains same.

The leverage value becomes greater than 2 after taking loans which in turn increases ROE.