Two 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 return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T) r_d.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

Since HD has a higher debt ratio, its cost of capital is also higher due to the higher financial risk. However, HD's ROIC exceeds its after-tax cost of debt, which means that its use of debt has increased its return to equity holders. Therefore, HD's ROE will be higher than LD's. However, the higher financial risk also means that HD's standard deviation of ROE will also be higher than LD's. Thus, choice B is correct. Choices A, C, D, and E are incorrect as they are not supported by the information given in the question.

Two Operationally Similar Companies, HD and LD, Have Identical Amounts