Return On Equity (ROE)

The importance of company debt in boosting ROE. Take two different companies. Each one has assets worth €1,000. The first has funded its assets with 800 in borrowed money and 200 in equity from investors. Assuming that the interest rate is 10% and the tax rate is 50%. Each year the €1,000 worth of assets produce €200 in operating profits. €80 goes to paying interest, which government allows you to charge as an expense. And of the remaining €120, €60 goes to tax and the other €60 goes to the equity holders. For their investment of €200, the equity holders receive an annual return of 30%.

Now imagine the same company in which all the €1,000 assets were funded with equity. They produce the same €200 in operating profits. There is no interest payment. €100 goes to paying taxes, leaving the equity holders with €100, a 10% return.