Financial Leverage and ROE

An analyst interpreting the past behavior of a firm's ROE or forecasting its future value must pay careful attention to the firm's debt-equity mix and to the interest rate on its debt. An example will show why. Suppose Nodett is a firm that is all-equity financed and has total assets of $100 million. Assume it pays corporate taxes at the rate of 40% of taxable earnings.

Table 13.4 shows the behavior of sales, earnings before interest and taxes, and net profits under three scenarios representing phases of the business cycle. It also shows the behavior of accounting earnings

Earnings of a firm as reported on its income statement.

economic earnings

The real flow of cash that a firm could pay out forever in the absence of any change in the firm's productive capacity.

return on equity (ROE)_

The ratio of net profits to common equity.

Taming Taxes

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