If the debt-to-assets ratio is 50 percent,the interest rate on all debt is 8 percent,the tax rate is 50 percent,and the return on equity is 10 percent,then the ratio of earnings before interest and taxes (EBIT)to total assets,or the basic earning power ratio,must be
A) 10%.
B) 14%.
C) 12%.
D) 8%.
E) 16%.

Question

Quizplus · Accepted Answer

The basic earning power (BEP) ratio is calculated as EBIT/Total Assets. Given a debt-to-assets ratio of 50%, it means that for every $1 of assets, there is $0.50 of debt. With an interest rate of 8% on the debt, the interest expense is 0.08 * 0.50 = $0.04 for every $1 of assets. The return on equity (ROE) of 10% applies to the equity portion of the assets, which is also 50% (since debt-to-assets is 50%, the remainder is equity). Thus, the earnings from equity are 0.10 * 0.50 = $0.05 for every $1 of assets. To find the EBIT, we need to adjust the earnings from equity by the tax effect on the interest expense, because EBIT does not consider taxes but does include interest expenses. The tax savings from the interest expense is 0.04 * 0.50 (50% tax rate) = $0.02. Therefore, the total earnings (EBIT) per $1 of assets are the sum of earnings from equity and the tax savings from the interest expense: $0.05 (earnings from equity) + $0.02 (tax savings) = $0.07. To find the BEP ratio, we divide EBIT by total assets, which in this case is $0.07/$1 = 7%. However, this calculation seems to have misunderstood the relationship between the components. Let's correct the approach:Given:- Debt-to-assets ratio = 50% or 0.5- Interest rate on debt = 8%- Tax rate = 50%- Return on equity (ROE) = 10%We need to find the EBIT/Total Assets ratio. The debt-to-assets ratio indicates that half of the assets are financed by debt. The cost of debt before tax is 8% of 50% of the assets. However, the question asks for the overall earnings power of the assets before interest and taxes, not just the net income after these factors.The correct approach involves understanding that the basic earning power (BEP) ratio is not directly influenced by the tax rate or the return on equity in its calculation. Instead, it focuses on how effectively a company uses its assets to generate earnings before interest and taxes (EBIT).Given the information, we can't directly calculate EBIT from the provided data without making assumptions about the total assets or earnings. However, we can infer the relationship between the cost of debt and the overall earning power needed to achieve a certain return on equity under the given conditions.The mistake in the initial explanation was trying to directly calculate EBIT and tax savings without recognizing that the BEP ratio is a measure of how effectively a company generates earnings from its assets, independent of how those assets are financed (with debt or equity).To achieve a return on equity (ROE) of 10% with a debt-to-assets ratio of 50% and an interest rate of 8%, the company's overall earning power must be sufficient to cover the interest expenses and provide the equity holders with their required return. The tax rate affects the net income but not the EBIT directly.The correct answer involves understanding that the BEP ratio is intended to reflect the company's ability to generate earnings from its assets before the impact of financing decisions (like interest expenses and taxes). However, without specific figures for EBIT or total assets, we cannot accurately calculate the BEP ratio from the information given. The initial attempt to calculate it based on the return on equity and tax savings was incorrect because it conflated different financial metrics and their purposes.Revisiting the question with the correct understanding that we cannot directly calculate the BEP ratio from the given information without additional data on EBIT or total assets, it's clear that the initial explanation was misguided. The correct answer should be derived from understanding the relationship between the cost of debt, the operational efficiency of the company, and how these factors contribute to the overall earning power of the assets before interest and taxes. Given the error in the initial explanation and calculation, let's correct the approach to align with the principles of financial analysis:To find the basic earning power (BEP) ratio, which is EBIT/Total Assets, we need to understand how the given financial ratios and rates interact. The debt-to-assets ratio of 50% indicates that half of the company's assets are financed through debt. The interest rate on this debt is 8%, but this interest rate affects the cost of debt, not directly the BEP ratio.The BEP ratio is intended to show how effectively a company generates earnings from its assets before the cost of financing (interest) and taxes are taken into account. Therefore, the tax rate and the return on equity (ROE) are not directly used in calculating the BEP ratio.Given the misunderstanding in the initial explanation, the correct approach to determining the BEP ratio from the information provided is not straightforward because the actual EBIT figure or total assets value is not given. The question seems to be asking for a conceptual understanding of how these financial metrics interact rather than a direct calculation.In conclusion, the correct answer should reflect an understanding of the BEP ratio's purpose and how it's influenced by the company's operational efficiency and asset utilization, not the financing structure or tax implications. The initial attempt to calculate it based on incorrect assumptions led to a misunderstanding of the question's requirements.

If the Debt-To-Assets Ratio Is 50 Percent,the Interest Rate on All