Profit from assets financed with debt 500 x 20 less

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Profit from assets financed with debt ($500 x 20%) . Less interest expense from debt ($500 x 7%) . Net profit. . $200 $100 (35) 65 $265 Wesee that this company has increased its profit to $265 (up from $200) with the addition of debt, and its ROE is now 26.5% ($265/$1,000). The reason for the increased ROE is that the company borrowed $500 at 7% (and paid $35 of interest expense) and invested those funds in assets earning 20% (which generated $100 of profits). That difference of l3% ($65 profit, computed as [20% - 7%] X $500) accrues to shareholders. Stated differently, the company's ROE now consists of the following. ROE = Operating return + Nonoperating return = 20% + 6.5% = 26.5% The company has made effective use of debt to increase its ROE. Here, we infer the nonoperating return as the difference between ROE and RNOA. This return can be computed directly, and we provide an expanded discussion of this computation in Appendix 3A. Advantages and Disadvantages of Equity versus Debt Financing We might further ask: If a higher ROE is desirable, why don't companies use the maximum possible debt? The answer is that creditors, such as banks and bondholders, charge successively higher interest rates for increasing levels of debt (see Module 7). At some point, the cost of the additional debt exceeds the return on the additional assets acquired from the debt financing. Thereafter, further debt financing does not make economic sense. The market, in essence, places a limit on the level of debt that a company can effectively acquire. In sum, shareholders benefit from increased use of debt provided that the assets financed with the debt earn a return that exceeds the cost of the debt. Creditors usually require a company to execute a loan agreement that places varying restric- tions on the company's operating activities. These restrictions, called covenants, help safeguard debtholders in the face of increased risk. Covenants exist because debtholders do not have a voice on the board of directors like stockholders do. These debt covenants impose a "cost" on the company beyond that of the interest rate, and these covenants are more stringent as a company increases its reliance on debt financing.
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Module 3 I Profitability Analysis and Interpretation 3-18 RESEARCH INSIGHT Ratio Behavior over Time ow do RNOA and ROE behave over time? Following is a graph of these ratios (on average for a large set of firms) over the past decade. We see there is considerable variability in these ratios over time. The proportion of RNOA to ROE is greater for some periods of time than for others. Yet, in all periods this large sample of firms, ROE exceeds RNOA. This is evidence of a positive effect, on average, - ROE from financial leverage. 8% a ..- ---- ...... , ~ ~ ~ ..•... .•. ..... •.•... ~ -- :+RNOA •••• ROE~ 16% 14% 12% 10% 6% 4% 2% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 ancial Leverage Across Industries ·e have seen, companies can effectively use debt to increase ROE with returns from non- ~ ting activities. The advantage of debt is that it typically is a less costly source of financ- _ urrently the cost of debt is about 4% versus a cost of equity of about 12%, on average.
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