Question

I understand calculating the initial ROE as well as the leveraged NI. I am confused for the debt and equity and calculating the return with 6% and 8%. I understand that leverage works both ways. It improves ROE if the firm's underlying return on capital is higher than the rate it paid to borrow money. Needing an explanation for return.  

Leverage (Similar to 2.14) Jay has a business in which he's invested $100,000 of his own money, which is the firm's only capital. (There are no other equity investors and no debt.) In a recent year the firm had net income of $7,000 1) What is the return on equity of the firm? 2) What will the firm's return on equity be next year if net income from business operations remains the same but it borrows $40,000 returning the same amount to Jake from the equity account if a. The after tax interest rate is 6%. b. The after tax interest rate is 8%. c. Comment on the difference between the results of a and b. Capital NI: S 100,000.00 $ 7,000.00 Return NI/EQ 1) Current ROE: 7% 2) Leveraged: 6% 3% Earnings Interest (after tax) NI $ 100,000.00 6,000.00 $ 94,000.00 $100,000.00 $ 8,000.00 92,000.00 Debt Equity Total Capital Return S 40,000.00 S 60,000.00 S 100,000.00 94% $40,000.00 60,000.00 S100,000.00 92%

Answer 1

for formulas and calculations, refer to the image below -