A profitability measure of ROE is affected by the level of a firm’s debt. Thus, an investor must consider the debt-equity ratio to evaluate the firm’s profitability. The debt-equity ratio determines a firm’s financial leverage which indicates how much of assets the firm is able to deploy for each monetary unit of stockholders’ equity. 1) Explain how the financial leverage effect can be defined as the difference between ROE and ROA. 2) Explain how the financial leverage effect is affected by the debt ratio and the interest rate.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
A profitability measure of ROE is affected by the level of a firm’s debt. Thus,
an investor must consider the debt-equity ratio to evaluate the firm’s
profitability. The debt-equity ratio determines a firm’s financial leverage which
indicates how much of assets the firm is able to deploy for each monetary unit
of
1) Explain how the financial leverage effect can be defined as the difference
between ROE and ROA.
2) Explain how the financial leverage effect is affected by the debt ratio and the
interest rate.
The effect of financial leverage is the difference between ROE and ROA because ROE is a measure that tells about the returns earned for Equity shareholders while returns on asset is a measure that tells returns earned on total assets used. So if deduct the returns then we will get the extra returns earned to the leverage effect because the difference between assets and equity is liabilities which tells about the debt or leverage effect.
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