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Borrrowings and Return on Common Equity

Explain why borrowing might lever up the return on common equity?

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Interest paid on borrowings is a tax-deductible expanse. It provides a shield to taxable income from federal and state taxes. It decreases the cash flow towards taxes. Thus more money goes to debt as well as equity holders.

Let us consider table given below. Firm A's assets are 100% equity based. Debt to Asset ratio of firm B is 0.5 i.e. $25000 from equity and $25000 from debt (@11% p.a.) Suppose both firms have same risks and EBIT of $7500.

Firm A Firm ...

Solution Summary

Solution describes how can borrowings can increase in return on common equity. It is explained with suitable examples.