Two companies, A and B, both have $1 million in assets, earnings before interest and taxes (EBIT) of $160,000, and the same tax rate. Company A is all equity financed, and Company B is 50% debt financed and 50% equity financed. If Company B's pretax cost of debt is 8%, then Company A will have a ROA that is _____ and a ROE that is _____ than Company B's. $$\begin{array} { l c c }
& \underline { \text { ROA } } & \underline { \text { ROE } } \
\text { A) } & \text { lower } & \text { higher } \
\text { B) } & \text { higher } & \text { higher } \
\text { C) } & \text { lower } & \text { lower } \
\text { D) } & \text { higher } & \text { lower }
\end{array}$$
A)Option A
B)Option B
C)Option C
D)Option D

Question

Two companies, A and B, both have $1 million in assets, earnings before interest and taxes (EBIT) of $160,000, and the same tax rate. Company A is all equity financed, and Company B is 50% debt financed and 50% equity financed. If Company B's pretax cost of debt is 8%, then Company A will have a ROA that is _____ and a ROE that is _____ than Company B's. $$\begin{array} { l c c } 
& \underline { \text { ROA } } & \underline { \text { ROE } } \
\text { A) } & \text { lower } & \text { higher } \
\text { B) } & \text { higher } & \text { higher } \
\text { C) } & \text { lower } & \text { lower } \
\text { D) } & \text { higher } & \text { lower }
\end{array}$$
A)Option A
B)Option B
C)Option C
D)Option D

Quizplus · Accepted Answer

ROA (Return on Assets) is calculated as EBIT/Total Assets. Since both companies have the same EBIT and total assets, their ROA will be the same, contradicting the premise of the question. However, for the purpose of answering based on the given options, we'll proceed with the analysis of ROE (Return on Equity).ROE for Company A (all equity) is EBIT/Equity. For Company B (50% debt), interest expense reduces EBIT, but since only half of the assets are financed by equity, the denominator in the ROE calculation is smaller. The cost of debt (8%) is less than the return on assets (EBIT/Assets), so leveraging (using debt) increases the return on equity for Company B compared to Company A. Thus, Company A will have a higher ROA (since it doesn't pay interest, and assuming ROA is considered on an operational basis) and a lower ROE because it doesn't benefit from the leverage that Company B does.

Two Companies, a and B, Both Have $1 Million in Assets