Suppose Firms A and B have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate.However, Firm A has a higher debt ratio.If BEP is greater than the interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio.

Question

Quizplus · Accepted Answer

When BEP is greater than the interest rate on debt, a higher debt ratio can magnify ROE as long as the additional debt is able to increase earnings more than the cost of the debt. This is known as financial leverage. Therefore, Firm A's higher debt ratio can result in a higher ROE if it can generate enough additional earnings to offset the higher interest payments.

Suppose Firms a and B Have the Same Amount of Assets