Under what conditions would a firm’s return on common equity (ROCE) be equal to its return...

Under what conditions would a firm’s return on common equity (ROCE) be equal to its return on net operating assets (RNOA)? Answer in paragraph form.

Expert Solution

Return on Common equity is a profitability measure which determines how much the company is earning per dollar of its common stock invested. ROCE is affected by the financial leverage of the company as well as the spread or the difference between the return net operating assets and total net borrowing cost (NBC).It has three drivers, a) Return on Net Operating assets b) Financial leverage and c) Operating spread. Financial leverage determines how much of net financial obligations (NFO) are used to finance net operating assets. The relationship or the degree to which ROCE is affected by financial leverage is expressed as follows

ROCE = Return on Net Operating assets (RNOA) + ( Financial leverage * Operating spread)

or ROCE = RNOA + ( Financial leverage * (RNOA - NBC)

Therefore, when the operating spread is zero, RNOA = NBC, then ROCE = RNOA

and also when financial leverage is zero, that is financial assets = financial obligations, then ROCE = RNOA.

jeff jeffy answered 1 year ago

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