Question

Faber Products has $35 million of sales and $9.75 million of net income. Its total assets are $150 million. Assume the company’s total assets equal total invested capital, and its capital structure consists of 40% debt and 60% common equity. The firm’s interest rate is 4%, and its tax rate is 21%. What would happen if this firm used less leverage (debt)? (The size of the firm does not change.) a. ROA would decrease, and ROE would increase. b. ROA would increase, and ROE would decrease. c. ROA would stay exactly the same, and ROE would decrease. d. Both ROA and ROE would decrease. e. Both ROA and ROE would increase.

Answer 1

If Capital structure consist 40% debt and 60% equity

Return on Assets = Net Income/Total Assets

= 9.75/150 = 6.5%

Return on Equity = Net Income/Shareholder’s Equity

= 9.75/90 = 10.83%

If the firm used less leverage (Debt), then

(i) Return on Assets will increase since Net income would be increased due to less Burdon of interest expenses on debt.

(ii) Return on Equity will decrease since Net income would be increased due to less Burdon of interest expenses on debt and Shareholder’s Equity would be Increase as denominator.

Let’s understand with an example:

Assume debt component in Capital structure reduced to 20%

Return on Assets = Net Income/Total Assets

= 10.70/150 = 7.13%

Return on Equity = Net Income/Shareholder’s Equity

= 10.70/120 = 8.92%

Therefore option (b) is correct answer, ROA would increase, and ROS would decrease.