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Look at the formula ROE = ROA*EM, and think of two ways to increase ROE. Which...

Look at the formula ROE = ROA*EM, and think of two ways to increase ROE. Which is easier?

A: Increasing EM is easier, since it can be done by simply issuing more equity.

B:Increasing EM is easier, since it can be done by simply granting more loans or buying back shares.

C:Increasing ROA is easier, since it can be done by simply choosing higher return assets with the same risk profile.

D:Increasing ROA is easier, since it can be done by simply raising the interest rates on loans

Please give me the answer with explanation as well. Thank you!

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Answer #1

Option-(B): Increasing EM is easier, since it can be done by simply granting more loans or buying back shares. Reason: In the formula ROE ROA x EM, ROE stands for Return on Equity; ROA stands for Return on Assets; EM stands for Equity Multiplier. where ROA Net Income/Total Assets; EM Total Assets/ Equity. Option-(A): Increasing EM is easier, since it can be done by simply issuing more equity is incorrect because when more equity is issued, EM will decrease as the numerator and denominator increases by same amount, mathematically Option-(B): Increasing EM is easier, since it can be done by simply granting more loans or buying back shares is correct because by granting more loans, firms assets will remain unchanged as loan receivable will be increased and cash balance will be decreased; Also, when the firm is buying back its shares, cash will be decreased but at the same time firms equity will also be decreased. As a result, EM will be then increased Option-(C): Increasing ROA is easier, since it can be done by simply choosing higher return assets with the same risk profile is incorrect because choosing a risk-free cum higher return yielding asset is not a easy task for a firm. Option-(D): Increasing ROA is easier, since it can be done by simply raising the interest rates on loans is incorrect because raising interest on loans offered involves many procedures and staturoty compliance

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