What is the scope of the return on equity model (ROE)? Which two important elements does...

What is the scope of the return on equity model (ROE)? Which two important elements does it incorporate?

Why is financial leverage a double-edged sword?

Solutions

Expert Solution

ROE incorporates the two important elements of Return on

Assets and the Equity multiplier (Financial leverage), such

that

ROE = Return on assets*Equity multplier.

The model suggests that ROE can be improved by improving

either of the two ratios--ROA or Equity multiplier.

ROA is again the product of Profit margin and Total asset

turnover. Improvement in either of these two ratios or both

will result in higher return on total assets.

Improvement in equity multiplier (given as Total Assets/Equity)

can be achieved by reducing the equity, that is increasing

financial leverage by increasing the debt content.

However, high financial leverage in times of lower return on

assets in times of recession can be counterproductive.

Hence, it can be summed up that financial leverage is a double

edged sword. High financial leverage is advantageous when

ROA is higher than the cost of debt and disadvantageous when

ROA is lower than the cost of debt.

jeff jeffy answered 1 year ago

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