Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company HD has a higher debt ratio. Which of the following statements is correct?
A) Company LD has a higher basic earning power ratio (BEP).
B) Company HD has a higher basic earning power ratio (BEP).
C) If the interest rate the companies pay on their debt is MORE THAN their basic earning power (BEP), then Company HD will have the higher ROE.
D) If the interest rate the companies pay on their debt is LESS THAN their basic earning power (BEP), then Company HD will have the higher ROE.

Question

Quizplus · Accepted Answer

If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then the higher the debt ratio the higher the ROE. This is because as the debt ratio increases, the cost of equity decreases due to the increasing financial leverage. Therefore, Company HD will have a higher ROE than Company LD. Choice A and B cannot be determined solely based on the given information, and choice C is incorrect as it states "MORE THAN" instead of "LESS THAN".

Companies HD and LD Have the Same Total Assets, Sales