Companies Heidee and Leaudy have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt.However, company Heidee has a higher debt ratio.Which of the following statements is CORRECT?
A) If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE.
B) Given this information, Leaudy must have the higher ROE.
C) Company Leaudy has a higher basic earning power ratio (BEP).
D) Company Heidee has a higher basic earning power ratio (BEP).
E) If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company Heidee will have the higher ROE.

Question

Quizplus · Accepted Answer

Since Heidee has a higher debt ratio, it will have a higher financial leverage. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then the higher financial leverage of Heidee will lead to a higher ROE. This is because financial leverage helps magnify the returns on equity when the cost of debt is less than the return on assets. Therefore, Leaudy may not necessarily have the higher ROE. The information provided does not give any insight into the basic earning power ratio (BEP) of either company, so options C and D cannot be determined. Option E is incorrect as it states the opposite of option A.

Companies Heidee and Leaudy Have the Same Total Assets, Sales