Question: Firm 1 has a capital structure with 20% debt and 80% equity. Firm 2s capital structure consists of 50% debt and 50% equity. Both firms

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?

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