Two operationally similar companies,HD and LD,have the same total assets,operating income (EBIT),tax rate,and business risk.Company HD,however,has a much higher debt ratio than LD.Also HD's basic earning power (BEP)exceeds its cost of debt (r_d).Which of the following statements is CORRECT? A) HD should have a higher times interest earned (TIE) ratio than LD. B) HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's. C) Given that BEP r_d, HD's stock price must exceed that of LD. D) Given that BEP r_d, LD's stock price must exceed that of HD. E) HD should have a higher return on assets (ROA) than LD.

Question

Two operationally similar companies,HD and LD,have the same total assets,operating income (EBIT),tax rate,and business risk.Company HD,however,has a much higher debt ratio than LD.Also HD's basic earning power (BEP)exceeds its cost of debt (r_d).Which of the following statements is CORRECT? A) HD should have a higher times interest earned (TIE) ratio than LD. B) HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's. C) Given that BEP > r_d, HD's stock price must exceed that of LD. D) Given that BEP > r_d, LD's stock price must exceed that of HD. E) HD should have a higher return on assets (ROA) than LD.

Quizplus · Accepted Answer

Since HD has a higher debt ratio, it will have a higher interest expense, and therefore, a lower net income. However, since HD's basic earning power (BEP) exceeds its cost of debt, its return on equity (ROE) should be higher than LD's. However, HD's higher debt ratio will also increase its financial risk and therefore, the riskiness of its ROE, as measured by standard deviation, should be higher than LD's. Hence, statement B is correct. Statements A, C, D, and E are incorrect as they are not related to the given information.

Two Operationally Similar Companies,HD and LD,have the Same Total Assets,operating