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 return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T)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 ROIC (1-T) r_d, HD's stock price must exceed that of LD. D) Given that ROIC (1-T) 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 return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T)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 ROIC > (1-T) r_d, HD's stock price must exceed that of LD. D) Given that ROIC > (1-T) 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 financial leverage, which can magnify the returns to equity shareholders in good times but can also magnify losses in bad times. This implies that HD should have a higher ROE than LD, but its risk (as measured by the standard deviation of ROE) should also be higher than LD's.
Option A cannot be determined as we do not have any information about the TIE ratios of HD and LD.
Option C and D are incorrect as stock price is dependent on various other factors and cannot be concluded based on ROIC only.
Option E cannot be determined as we do not have any information about the ROA of HD and LD.

Two Operationally Similar Companies, HD and LD, Have the Same