operationally similar companies, HD and LD, have identical amounts of assets, operating income (EBIT), tax rates, and business risk Company HD, however, has a much higher debt ratio than LD Company HD's basic earning power ratio (BEP) exceeds its cost of debt (rd) Which of the following statements is CORRECT?
A) Company HD has a higher times interest earned (TIE) ratio than Company LD.
B) Company HD has a higher return on equity (ROE) than Company LD, and its risk, as measured by the standard deviation of ROE, is also higher than LD's.
C) The two companies have the same ROE.
D) Company HD's ROE would be higher if it had no debt.
E) Company HD has a higher return on assets (ROA) than Company LD.

Question

Quizplus · Accepted Answer

The fact that Company HD has a higher debt ratio than LD but still has a higher BEP than its cost of debt indicates that the use of debt is increasing the return to shareholders. This is because debt is less expensive than equity, so using more debt can increase the return attributable to equity. Therefore, Company HD likely has a higher ROE than LD due to the increased financial leverage. However, the use of additional debt also increases the risk to shareholders, as measured by the standard deviation of ROE, so the risk of Company HD is higher than LD's. Statement A is incorrect because the TIE ratio, which measures the company's ability to cover interest expenses with EBIT, is not given or relevant information. Statement C is incorrect because it assumes that ROE is not affected by differences in capital structure, which is not necessarily true. Statement D is incorrect because adding debt to a company's capital structure can increase its ROE, all else equal, so removing the debt would likely decrease the ROE. Statement E is incorrect because there is no information given about the companies' ROAs.

Operationally Similar Companies, HD and LD, Have Identical Amounts of Assets