Reeves Corporation forecasts that its operating income (EBIT) and total assets will remain the same as last year, but that the company's debt ratio will increase this year. What can you conclude about the company's financial ratios? (Assume that there will be no change in the company's tax rate.)
A) The company's basic earning power (BEP) will fall.
B) The company's return on assets (ROA) will fall.
C) The company's equity multiplier (EM) will increase.
D) All of the answers above are correct.
E) Answers b and c are correct.

Question

Quizplus · Accepted Answer

If the company's EBIT and total assets remain the same, and its debt ratio increases, this means that the company is taking on more debt to finance its operations. This will lead to an increase in the equity multiplier (EM), which measures the amount of assets that are financed by debt compared to equity. The return on assets (ROA) will fall because the increase in debt will lower the company's net income, and therefore its profitability. However, the basic earning power (BEP) ratio will not be affected because it is a measure of operating income before interest and taxes, and assumes that the company has no debt. Therefore, the best choice is E, as it correctly identifies the two ratios that will be affected by the increase in debt.

Reeves Corporation Forecasts That Its Operating Income (EBIT) and Total