Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' basic earning power (BEP) ratios exceed their cost of debt (rd). Which of the following statements is CORRECT?
A) HD should have a higher return on assets (ROA) than LD.
B) HD should have a higher times interest earned (TIE) ratio than LD.
C) HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
D) Given that BEP rd, HD's stock price must exceed that of LD.
E) Given that BEP rd, LD's stock price must exceed that of HD.

Question

Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' basic earning power (BEP) ratios exceed their cost of debt (rd). Which of the following statements is CORRECT?
A) HD should have a higher return on assets (ROA) than LD.
B) HD should have a higher times interest earned (TIE) ratio than LD.
C) HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
D) Given that BEP > rd, HD's stock price must exceed that of LD.
E) Given that BEP > rd, LD's stock price must exceed that of HD.

Quizplus · Accepted Answer

Since HD has a higher debt ratio, it will have a higher financial leverage and hence a higher ROE than LD. However, the higher financial leverage will also increase the riskiness of HD's equity, as measured by the standard deviation of ROE. Therefore, option C is correct. Option A is incorrect because ROA depends on both ROE and financial leverage, and it is not clear which effect dominates. Option B is incorrect because the TIE ratio depends only on EBIT and interest expense, and not on the debt ratio. Option D and E are incorrect because the relationship between stock price and BEP and rd is not given in the question stem.

Companies HD and LD Have the Same Total Assets, Operating