Suppose Firms A and B have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate.However, Firm A has a higher debt ratio.If BEP is greater than the interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio.

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the easiest way to think about this is to realize that you can borrow at a cost of 10% and invest the proceeds to earn 11%, you'll earn a surplus.If you were previously earning an ROE of 10%, then after raising and investing additional funds, your income will be higher, your equity will be the same, and thus your ROE will increase.Similarly, if a firm earns more on assets than the interest rate, there will be a surplus after paying interest on the debt that will go to the equity, thus increasing the ROE.So, if BEP > rd, then the firm can increase its expected ROE by using more debt leverage.the answer can also be seen by working out an example.the one below shows that leverage increases ROE if BEP > rd, but it could be varied to show no difference in ROE if interest rates and BEP are the same, and a reduction in ROE if the interest rate exceeds the BEP. 11ea1b84_8b78_6f14_a54a_fb896e71faae_TB3581_00

Suppose Firms a and B Have the Same Amount of Assets