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
5% 10% 15% 20% 25% 5% 10% 15% 20% 25%
ROI
5 10 15 20 25 5 10 15 20 25
PBIT (million)
0 0 0 0 0 5 5 5 5 5
Less: int
5 10 15 20 25 0 5 10 15 20
PAT
2.5 5 7.5 10 12.5 0 2.5 5 7.5 10
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% 5% 10% 15% 20%
ROE
ROE

30 B

25
A
20

15

10

5 10 15 20 25 30 ROI
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%