Question

In: Finance

If the interest coverage ratio is too high, then the ROE is too low, Agree or...

If the interest coverage ratio is too high, then the ROE is too low, Agree or Not ?

What the three factor affect ROE and how higher ROE lead to higher share price ?

Expert Solution

1.NO.Do not agree.

Interest coverage ratio=EBIT/Interest expense

Return on Equity=Net income/Total Equity

If interest coverage ratio is too high, it means that either

1.EBIT, ie Earnings before interest & taxes is high OR

2.Interest expense is low.

In both the above cases, net income will be increasing .(EBIT-Int.-Taxes)

Hence ROE wil not be too low.

2. Three factors that affect ROE

According to the DuPont equation for ROE,

ROE= Profit margin*Total assets turnover*Financial leverage

so, 1.the level of profit margin to sales--ie. Operational efficiency

2. the level of $ sales that is generated by deploying per $ of the assets-- the assets usage efficiency &

3. the level of debt in funding the assets, the optimium the better--

are the three main factors that drive the return to equity

Higher ROE lead to higher share price

as incresaing ROE is an indication of good returns on the equity capital

as well as better usage of the equity funds

thus instilling confidence in the potential investors to invest funds in the company.

Thus the demand for the company's shares goes up in the market

pushing up the stock prices

jeff jeffy answered 6 months ago

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