Then the no debt company obviously has no interest expense, so
their pretax income is 300, we take off taxes at 35%, and their net income is 195.
For the company that has some debt, they have interest expense.
So if they had 50 of interest expense, their pre-tax income would only be 250.
We take off taxes and their net income is only 162.5.
So if we use net income in the numerator for ROA, then ROA is gonna be
affected by the fact that the some debt firm has some borrowing.
Now if you look in the last row, we're gonna calculate de-levered net income We
don't have to do anything for the no debt firm cuz it has no interest expense.
For the some debt firm we take net income plus interest expense times 1
minus the tax rate and we end up with de-levered net income of 195
which is identical to the de-levered net income of the no debt firm.
So using de-levered net income in ROA gives us a measure of ROA that only
measures operating performance.
Now when we use ROE, we do want the interest expense in there because
ROE does wanna reflect the effective financing.
So we take the financing out of ROA but we leave the financing in for ROE.