Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also HD's basic earning power (BEP) exceeds its cost of debt (rd). Which of the following statements is CORRECT?
A) HD should have a higher return on assets (ROA) than LD.
B) HD should have a higher times interest earned (TIE) ratio than LD.
C) HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be
Higher than LD's.
D) Given that BEP rd, HD's stock price must exceed that of LD.
E) Given that BEP rd, LD's stock price must exceed that of HD.

Question

Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also HD's basic earning power (BEP) exceeds its cost of debt (rd). Which of the following statements is CORRECT?
A) HD should have a higher return on assets (ROA) than LD.
B) HD should have a higher times interest earned (TIE) ratio than LD.
C) HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be
Higher than LD's.
D) Given that BEP > rd, HD's stock price must exceed that of LD.
E) Given that BEP > rd, LD's stock price must exceed that of HD.

Quizplus · Accepted Answer

Higher debt increases financial leverage, which can increase ROE if BEP > rd, but it also increases risk, leading to higher ROE volatility.

Companies HD and LD Have the Same Total Assets, Operating