Companies HD and LD have the same total assets,total investor-supplied capital,operating income (EBIT),tax rate,and business risk.Company HD,however,has a much higher debt ratio than LD.Also,both companies' returns on investors' capital (ROIC)exceed their after-tax costs of debt,r_d(1 - T).Which of the following statements is CORRECT? A) HD should have a higher return on assets (ROA)than LD. B) HD should have a higher times interest earned (TIE)ratio than LD. C) 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. D) Given that ROIC r_d(1 - T),HD's stock price must exceed that of LD. E) Given that ROIC r_d(1 - T),LD's stock price must exceed that of HD.

Question

Companies HD and LD have the same total assets,total investor-supplied capital,operating income (EBIT),tax rate,and business risk.Company HD,however,has a much higher debt ratio than LD.Also,both companies' returns on investors' capital (ROIC)exceed their after-tax costs of debt,r_d(1 - T).Which of the following statements is CORRECT? A) HD should have a higher return on assets (ROA)than LD. B) HD should have a higher times interest earned (TIE)ratio than LD. C) 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. D) Given that ROIC > r_d(1 - T),HD's stock price must exceed that of LD. E) Given that ROIC > r_d(1 - T),LD's stock price must exceed that of HD.

Quizplus · Accepted Answer

The fact that both companies have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk indicates that their operating conditions are the same. However, the higher debt ratio of HD means that it has a higher financial risk, which translates into a higher cost of equity. The fact that both companies' returns on investors' capital (ROIC) exceed their after-tax costs of debt indicates that they are able to generate returns in excess of their capital costs. Therefore, both companies should have higher return on equity (ROE) than their after-tax cost of debt, but the magnitude of HD's ROE should be higher due to the higher financial leverage. However, the higher financial leverage means that HD's risk, as measured by the standard deviation of ROE, should also be higher than LD's. Therefore, the correct answer is C.

Companies HD and LD Have the Same Total Assets,total Investor-Supplied