Question

If a firm’s ROE is low and management wants to improve it, explain how using more debt might help.

Answer 1

ROE or return on equity is given by the formula

ROE = (Net Profit)/ (Shareholder's equity)

Now, to improve ROE two factors can help make it possible,

a) Either increase the numerator ie Net Profit

b) Decrease the denominator ie Shareholder's Equity

By using Debt, the company can yield tax benefits on the interest payment for that debt as interest payment is a tax shield. This tax shield would lower the tax payment thus increasing the net profits. Subsequently, denominator can be decreased if a proportion of equity is replaced by debt.

For example, if a company having a capital of $ 100 is funded entirely by equity and let the EBIT be 50 with tax rate 50%. Now, Net profit is 25 and ROE = 25/100 = 25%

Let $ 50 of equity be now replaced with $50 of debt with 10% interest rate. So EBIT = 50 and Interest = 5, so EBT =45

Net profit = 22.5, Thus ROE = 22.5/50 = 45%

Thus when we replace debt with equity we find that the ROE has improved.