Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt-HD has more debt and pays a higher interest rate on that debt.Based on the data given below,what is the difference between the two firms' ROEs?
$$\begin{array}{l}
\begin{array} { l }
\underline{({\text { Applicable to Both Firms }})}\
\text { Assets } & \$ 200 \
\text { EBIT } & \$ 40\
\text { Tax rate } & 35 \%\
\end{array}

\begin{array} { l }
\underline{( {\text { Firm HD's Data }})}\
\text { Debt ratio } & 50 \%\
\text { Interest rate } & 12 \% \
\end{array}

\begin{array} { l }
\underline{({\text { Firm LD's Data }})}\
\text { Debt ratio } & 30 \%\
\text { Interest rate } & 10 \% \
\end{array}

\end{array}$$

A) 2.18%
B) 2.29%
C) 2.41%
D) 2.54%
E) 2.66%

Question

Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt-HD has more debt and pays a higher interest rate on that debt.Based on the data given below,what is the difference between the two firms' ROEs?
 $$\begin{array}{l}
\begin{array} { l } 
\underline{({\text { Applicable to Both Firms }})}\
\text { Assets } & \$ 200 \
\text { EBIT } & \$ 40\
\text { Tax rate } & 35  \%\
\end{array}

\begin{array} { l } 
\underline{( {\text { Firm HD's Data }})}\
\text { Debt ratio } & 50 \%\
\text { Interest rate } & 12 \%  \
\end{array}

\begin{array} { l } 
 \underline{({\text { Firm LD's Data }})}\
\text { Debt ratio } & 30 \%\
\text { Interest rate } & 10 \%  \
\end{array}

\end{array}$$

A) 2.18%
B) 2.29%
C) 2.41%
D) 2.54%
E) 2.66%

Quizplus · Accepted Answer

$$\begin{array}{l}
\begin{array} { l } 
\underline{({\text { Applicable to Both Firms }})}\
\text { Assets } & \$ 200 \
\text { EBIT } & \$ 40\
\text { Tax rate } & 35  \%\
\end{array}
\begin{array} { l } 
\underline{( {\text { Firm HD's Data }})}\
\text { Debt ratio } & 50 \%\
\text { Interest rate } & 12 \%  \
\end{array}
\begin{array} { l } 
 \underline{({\text { Firm LD's Data }})}\
\text { Debt ratio } & 30 \%\
\text { Interest rate } & 10 \%  \
\end{array}
\end{array}$$
 $\begin{array}{lcr}
\text { Debt }= & \$ 100.0 & \$ 60.0 \
\text { Interest }=\mathrm{I}= & \$ 12.0 & \$ 6.0 \
\text { Taxable income }=\mathrm{EBIT}-\mathrm{I}= & \$ 28.0 & \$ 34.0 \
\mathrm{NI}=(\text { Taxable Income })(1-\mathrm{T})= & \$ 18.2 & \$ 22.1 \
\text { Equity }=\mathrm{A}-\text { Debt }= & \$ 100.0 & \$ 140.0 \
\mathrm{ROE}=\mathrm{NI} / \mathrm{Equity}= & 18.20 \% & 15.79 \%\
\text { Difference in }\mathrm{ROE}=2.41\%
\end{array}$

Firms HD and LD Are Identical Except for Their Level