Why Are Fluctuations In The Return On Equity Considered A Measure Of Total Project Risk?
It is considered a risk as the rate of return can be negative, thereby loss of principal. Here is an example to clarify the point – Suppose an organization has $1 million of equity funds and borrows $4 million at an interest rate of 8 percent. Its leverage ratio L is thus 4. If the $5 million in total funds is loaned or invested and brings a rate of return of 10 percent then it has earnings of $500,000. From this $500,000 it has to pay $320 thousand in interest, leaving $180 thousand as return on equity. On the $1 million of equity this $180 thousand is an 18 percent rate of return, a commendable rate of return. This is the positive side of leverage. But if due to unforeseen circumstances the rate of return on the invested funds falls to 6 percent then the organization has only $300 thousand in earnings and an interest bill of $320 thousand. This means the equity holders suffer a $20 thousand loss, a -2 percent rate of return.
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