Firms U and L both have a return on invested capital (ROIC) of 12% and each has the same amount of assets.Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity.Firm L's debt has an after-tax cost of 4.8%.Both firms have positive net income.Which of the following statements is CORRECT?
A) Firm L has a lower ROA than Firm U.
B) Firm L has a lower ROE than Firm U.
C) Firm L has the higher times interest earned (TIE) ratio.
D) Firm L has a higher EBIT than Firm U.
E) The two companies have the same times interest earned (TIE) ratio.

Question

Quizplus · Accepted Answer

DFirm L, which is leveraged, will have a lower Return on Assets (ROA) than Firm U because the interest expense on its debt reduces its net income relative to its assets. However, due to the leverage, Firm L can have a higher Earnings Before Interest and Taxes (EBIT) than Firm U if the return on the invested capital (ROIC) exceeds the cost of debt, which allows the firm to benefit from the leverage effect.

Firms U and L Both Have a Return on Invested