If a retailer with an ROA of 7.0 percent decides to increase its financial leverage ratio from 1.5 times to 2.0 times,which of the following results will occur?

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Quizplus · Accepted Answer

Increasing financial leverage means the retailer is using more debt relative to equity. This does not change the Return on Assets (ROA) directly, but it does affect the Return on Net Worth (RONW) or Return on Equity (ROE) because the same amount of profit is spread over a smaller equity base. If the ROA is 7.0% and the financial leverage ratio increases from 1.5 to 2.0, it implies that the earnings attributable to shareholders (as a percentage of their investment) would increase due to the higher leverage. The calculation for the original RONW at a leverage of 1.5 times would be ROA * leverage = 7.0% * 1.5 = 10.5%. With the leverage increasing to 2.0 times, the new RONW would be ROA * new leverage = 7.0% * 2.0 = 14.0%. This shows an increase in RONW from 10.5% to 14.0%, not a percentage increase in the ROA or a decrease in RONW as the other options suggest.

If a Retailer with an ROA of 7