Which of the following statements is CORRECT?
A) If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses.
B) A firm's use of debt will have no effect on its profit margin.
C) If two firms differ only in their use of debt--i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates--but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales and a lower return on assets.
D) The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable.
E) If two firms differ only in their use of debt--i.e., they have identical assets, sales, operating costs, and tax rates--but one firm has a higher debt ratio, the firm that uses more debt will have a higher operating margin and return on assets.

Question

Quizplus · Accepted Answer

The use of debt increases a firm's financial leverage, which magnifies both its profits and its losses. Therefore, if two firms differ only in their use of debt, the firm that uses more debt will have a higher return on assets when times are good but a lower return when times are bad. This implies that its profit margin and return on assets will both be lower.
The other statements are all false. 
A) The TIE ratio is a measure of a firm's ability to meet its interest payments, and it depends on both the amount of debt and the firm's operating income.
B) A firm's use of debt can affect its profit margin by increasing its interest expense, which reduces net income.
D) The debt ratio as it is generally calculated does not make an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets may not be comparable.
E) A higher debt ratio generally implies greater financial risk, which can lead to higher expected returns but also greater variability in earnings. Therefore, the claim that a firm with a higher debt ratio will have a higher operating margin and return on assets is false.

Which of the Following Statements Is CORRECT