Question

Why is the return on equity greater than the return on assets if the cost of debt is less than the ROA? Why is the ROE less than the ROA if the cost of debt is greater than the ROA? Why does the ROE equal the ROA if the cost of debt is equal to the ROA?

Answer 1

Return on equity is greater than return on assets because return on equity will be having the benefits associated with the overall cost of debt whereas return on assets will be the return for all of the equity shareholders as well as the debt share holders of the company so when tax element of debt will be deducted, it will mean that the rate of return on the equity shareholders will eventually be higher because it will not be eliminating for the cost of equity & it will just be eliminating for the overall debt and hence debt capital are always providing with the additional benefit of interest tax deduction to the company and it would be completely formulating with higher return on equity.

Return on equity will be less than return on assets because when the cost of debt will be higher, it will mean that the cost of equity will be comparatively lower and when the cost of equity will be lower it will be disadvantaged by the increasing cost of debt and when they will be equal, it will mean that the overall cost of equity and debt are falling almost similar so there is not much difference when there is a comparison between return on Assets and return on equity.