Question

The use of debt in the firm's capital structure will increase ROE if the firm:_____.

a. has more debt than equity.
b. pays less in taxes than in interest.
c. earns a higher return than the rate paid on debt.
d. has a times interest earned greater than 1.0.

Answer 1

Answer: c. earns a higher return than the rate paid on debt.

Step-by-step explanation:

If the debt that the company incurs leads to the company making more money than they are paying as interest for the debt, then more money will be available as net income which would increase the Return on Equity.

ROE is calculated by dividing the Net Income by Shareholder equity. Interest is an expense. If this expense is lower then the increase in net income as a result of the debt then it follows that net income would increase and so would ROE.