Firm 1 has a capital structure with 20 percent debt and 80 percent equity. Firm 2's capital structure consists of 50 percent debt and 50 percent equity. Both firms pay 7 percent annual interest on their debt.
Finally, suppose both firms have invested in assets worth $100 million. Calculate the return on equity (ROE) for each firm, assuming the following:
a. The return on assets is 3 percent.
b. The return on assets is 7 percent.
c. The return on assets is 11 percent. What general pattern do you observe?