Question

If Lester Corporation takes out a bank loan to purchase a machine used in production and everything else stays the same, its equity multiplier will ________, and its ROE will ________.

options:

decrease; increase

decrease; decrease

increase; increase

increase; decrease

Answer 1

Equity Multiplier = Increase

And Return on Equity = increase(because of financial leverage effect)

Explanation:

Let us Understand by a Practical Example.

====> Before taking Loan

Equity Share capital = $100000

Reserves = $100000

other Outside Liblities = $200000

Total = $400000

Fixed Asset = $300000

Other current asset = $100000

Total = $400000

Assume Earning After Tax = $10000

Equity Multipler Ratio = Total Assets / Total Share Holders Fund

= 400000/200000

= 2times

Return on Equity = EAT(net Income)/ Equity

= 10000/100000

= 10%

=============> After Taking loan

Assume 100000 Loan @ 5 % to purchase a machine

Net Income increase (because of production increase) = $20000 - 3500Interest Amount (100000loan amount X 5% X {1-30%} (assume 30% tax rate)

= 16500

Equity Share capital = $100000

Reserves = $100000

other Outside Liblities = $200000

Machine Loan = $100000

Total = $500000

Fixed Asset = $300000

Machine = $100000

Other current asset = $100000

Total = $500000

Equity Multipler Ratio = Total Assets / Total Share Holders Fund

= 500000/200000

= 2.5 Times

Return on Equity = EAT(net Income)/ Equity

= 16500/100000

= 16.5%

	Before Taking Loan	After Taking Loan	Result
Equity Multiplier	2 Times	2.5 Times	Increase
Return on Equity	10 Percent	16.5%	Increase

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