Lottadoe and Bigbux are two companies that are identical in every respect except that Lottadoe uses only equity financing while Bigbux relies heavily on debt financing. Over the past year, the firms had identical net incomes before interest and taxes were taken into account. If the firms faced a rough year with very low earnings, what would be the result?
A) Bigbux would be able to skip its interest payments if paying them would cause its net income to be negative.
B) Bigbux would report a higher net taxable income than Lottadoe.
C) Lottadoe would report a higher return on equity than Bigbux.
D) Lottadoe would be required to pay a higher dividend than Bigbux, thus reducing retained earnings.

Question

Quizplus · Accepted Answer

Since Lottadoe only uses equity financing, it does not have to pay interest expenses on debt. Therefore, in a rough year with low earnings, Lottadoe would still have the same net income as before. On the other hand, Bigbux, which relies heavily on debt financing, would have to pay interest expenses even if its net income was negative. This would result in a lower net income and a lower return on equity for Bigbux compared to Lottadoe. Therefore, Lottadoe would report a higher return on equity than Bigbux.

Lottadoe and Bigbux Are Two Companies That Are Identical in Every