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ROI ROE Analysis

This document analyzes the relationship between return on investment (ROI) and return on equity (ROE) for different capital structures. It shows that ROE under a capital structure with debt is higher than an all-equity structure when ROI exceeds the cost of debt, but lower when ROI is below the cost of debt. The break-even point where the ROEs are equal is when ROI matches the cost of debt. It provides an example comparing the ROEs of two capital structures, A and B, at different ROI levels to illustrate this relationship.

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Sankaranarayanan SR
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67 views

ROI ROE Analysis

This document analyzes the relationship between return on investment (ROI) and return on equity (ROE) for different capital structures. It shows that ROE under a capital structure with debt is higher than an all-equity structure when ROI exceeds the cost of debt, but lower when ROI is below the cost of debt. The break-even point where the ROEs are equal is when ROI matches the cost of debt. It provides an example comparing the ROEs of two capital structures, A and B, at different ROI levels to illustrate this relationship.

Uploaded by

Sankaranarayanan SR
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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ROI ROE Analysis

- Analysis of the relationship between the return


on Investment (ROI) and the Return on Equity
(ROE) for different levels of financial leverage .
Eg: Korex Ltd requires an invst of 100 million and
is considering two capital structures.
Capital Structure A Capital Structure B
Equity 100 Equity 50
Debt 0 Debt 50
Relationship between ROI & ROE
Particulars Capital structure A Capital structure B
ROI
5% 10% 15% 20% 25% 5% 10% 15% 20% 25%
PBIT (million)
5 10 15 20 25 5 10 15 20 25
Less: int
0 0 0 0 0 5 5 5 5 5
PAT
5 10 15 20 25 0 5 10 15 20
Less :tax
2.5 5 7.5 10 12.5 0 2.5 5 7.5 10
PAT
2.5 5 7.5 10 12.5 0 2.5 5 7.5 10
ROE
2.5% 5% 7.5% 10% 12.5
%
0% 5% 10% 15% 20%
ROE
ROI 5 10 15 20 25 30
5
10
15
20
25
30 B
A
Relationship between ROI and ROE
- ROE under capital structure A is higher than
ROE under capital structure B when ROI < cost of
Debt .
- ROE under the two capital structures is the
same when ROI = cost of Debt . Hence the
indifference (break even) value of ROI = cost of
Debt.
- ROE under capital structure B is higher than the
ROE under capital structure A when ROI > cost of
Debt
Mathematically it can be calculated
as follows.
ROE = [ROI+(ROI-Kd) D/E] (1-t)
Eg : Given D/E =1, Kd=10%, Tax rate = 50%
calculate the ROE when the ROI is 15% and 20%
- When ROI is 15%
ROE = [15+(15-10) 1] (1-0.5) = 10%
- When ROI is 20%
ROE = [ 20+(20-10) 1] (1-0.5) = 15%

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