Which of the following statements is CORRECT?
A) If two firms differ only in their use of debt⎯i.e., they have identical assets, sales, operating costs, and tax rates⎯but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales.
B) If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses.
C) A firm's use of debt will have no effect on its profit margin on sales.
D) If two firms differ only in their use of debt⎯i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates⎯but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales.
E) The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable.

Question

Quizplus · Accepted Answer

According to the statement, if two firms differ only in their use of debt but have identical assets, sales, operating costs, interest rates on their debt, and tax rates, the firm that uses more debt will have a lower profit margin on sales. This is because the higher interest expense associated with more debt reduces the net income of the firm, thereby lowering the profit margin on sales.

Which of the Following Statements Is CORRECT