Suppose that Chicken Express, Inc. has an ROA of 7% and pays a 6% coupon on its debt. Chicken Express has a capital structure that is 70% equity and 30% debt. Relative to a firm that is 100% equity-financed, Chicken Express's net profit will be ________, and its ROE will be ________.
A) lower; lower
B) higher; higher
C) higher; lower
D) lower; higher
E) It is impossible to predict.

Question

Quizplus · Accepted Answer

Chicken Express's net profit will be lower because it has to pay interest on its debt, which reduces its net income. However, its ROE will be higher because leveraging (using debt) magnifies the return on equity when the cost of debt is lower than the return on assets (ROA > interest rate on debt).

Suppose That Chicken Express, Inc