week 2 homework assignment (chapter 3) (latest update)

Fin 534: week 2 homework assignment (chapter 3) (latest update)

The return on equity (ROE) is a financial metric that measures the amount of profit generated by a company in relation to its total shareholders’ equity. It provides investors with an indication of the financial health and success of a firm, as well as its ability to generate returns for its owners.

When it comes to capital structure, this refers to the combination of debt and equity financing that is used by a business. A company’s capital structure will influence how much leverage it has and how much risk it takes on when borrowing money from lenders or raising funds from investors.

A change in capital structure can have an impact on ROE since it affects both profits and financing costs. When there is more debt financing, interest payments must be made which reduces profits; however, the cost of debt is generally lower than equity financing so overall less money needs to be devoted towards funding operations which can ultimately result in higher returns for shareholders. On the other hand, if more equity financing is used then there are greater liabilities associated with paying out dividends but no interest payments needed which also increases ROE.

Therefore, given that sales, operating costs, assets, the interest rate and tax rate all remain constant then when a change in capital structure occurs we would expect to see corresponding changes in ROE; if more debt was added we should observe an increase while increased use of equity would lead to a decline in ROE due to higher dividend payments being required without any offsetting reduction in interest payments like what we would find with additional use of debt financing.