Question

This year Andrews achieved an ROE of 11.6%. Suppose the Board of Directors of Andrews mandates that management take measures to increase financial Leverage (=Assets/Equity) next year. Assuming Sales, Profits, and Assets remain the same next year, what effect would you expect this new Leverage policy will have on Andrews ROE?

Answer 1

Answer: c. Andrews ROE will increase.

Explanation:

The Board of Directors has ordered that measures be put in place to increase financial Leverage which is Assets/Equity. That means that there are 2 ways this is to be done based on the formula which would be to either; increase Assets or Decrease Equity.

It is assumed that Sales, Profits, and Assets remain the same next year so the measures will therefore involve decreasing Equity.

Return on Equity = Net income/Shareholder equity.

Profits are assumed to remain the same, however, as per the Board's directives, Equity will fall. This will mean that Net Income will be divided by a lower figure which will lead to a higher ROE.