Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company HD has a higher debt ratio. Which of the following statements is CORRECT?
A) Given this information, LD must have the higher ROE.
B) Company LD has a higher basic earning power ratio (BEP).
C) Company HD has a higher basic earning power ratio (BEP).
D) If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company HD will have the higher ROE.
E) If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company HD will have the higher ROE.

Question

Quizplus · Accepted Answer

If the interest rate is less than the BEP, the use of debt (financial leverage) will enhance ROE for HD due to the positive spread between BEP and interest rate.

Companies HD and LD Have the Same Total Assets, Sales