Firm 1 has a capital structure with 20% debt and 80% equity. Firm 2’s capital structure consists of 50% debt and 50% equity. Both firms pay 7% annual interest on their debt. Finally, suppose that 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%.
b. The return on assets is 7%.
c. The return on assets is 11%.
What general pattern do you observe?