Companies HD and LD have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD's basic earning power ratio (BEP) exceeds its cost of debt (r). Which of the following statements is CORRECT?a)Company HD has a higher return on assets (ROA) than Company LD.b)Company HD has a higher times interest earned (TIE) ratio than Company LD.c)Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD's.d)The two companies have the same ROE.e)Company HD's ROE would be higher if it had no debt.

Question

25-10-2019
Business

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Companies HD and LD have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD's basic earning power ratio (BEP) exceeds its cost of debt (r). Which of the following statements is CORRECT?a)Company HD has a higher return on assets (ROA) than Company LD.b)Company HD has a higher times interest earned (TIE) ratio than Company LD.c)Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD's.d)The two companies have the same ROE.e)Company HD's ROE would be higher if it had no debt.

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Answer:

The answer is: C)Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD's.

Explanation:

Both companies have the same EBIT, even though company HD has a higher debt ration than company LD. This can only be explained if HD has a higher return on equity than LD (HD is a more profitable investment), since they are making the same amount of money (same EBIT) with less equity. Since they have less equity, they have larger debts. Then again, company HD will always be a riskier investment since its standard deviation of ROE is higher.