When calculating a firm’s return on total assets (ROA) ratio, some investment professionals modify the ROA ratio by adding back the interest expense paid by a firm to its creditors, on a net-of-taxes basis, as follows:

where i is the actual interest expense paid by a firm and the tax rate is a firm’s “effective tax rate” (income tax expense divided by pre-tax net income). Adjusting net income for the interest expense paid by a firm is called “unlevering net income” because the adjustment yields a measure of net income as if the firm were all equity financed (with no debt financing). Discuss when and why unlevering ROA might produce a more useful measure of the return on assets of a firm.

Transcribed Image Text:

Return on assets = [Net income+i(1- Tax rate)] Total assets