The use of debt in the firm's capital structure increases return on equity (ROE) if the firm earns higher returns as compared to the rates paid on debt. Thus the correct option is (c) i.e. ‘earns higher returns than the rates paid on debt.’
Debt is a way through which companies can raise money in the capital markets. Because of its advantages like tax-deductible, retaining ownership, and increasing return on equity, companies benefit from debt.
Debt increases return on equity in situations when the company earns higher profit than the interest rate it pays on debt. Ultimately, the increase in return on equity means that the company is efficient at converting its equity financing into profits.
While the other options are incorrect because:
None of them increases return on equity with a use of debt in a firm’s capital structure.
'The complete question is:
The use of debt in the firm's capital structure will increase roe if the firm:
a. has more debt than equity.
b. pays less in taxes than in interest.
c. earns a higher return than the rate paid on debt.
d. has a times interest earned ratio greater than 1.0.'
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