Firms HD and LD are identical except for their level of debt and the interest rates they pay on debtσHD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs?
$\begin{array}{lcll}
{\text { Applicable to Both Firms }} & {\text { Firm HD's Data }} & \text { Firm LD's Data } \
\text { Assets } & \$ 200 \text { Debt ratio } & 50 \% \text { Debt ratio } & 30 \% \
\text { EBIT } & \$ 40 \text { Interest rate } & 12 \% \text { Interest rate } & 10 \% \
\text { Tax rate } & 35 \% & &
\end{array}$

Question

Quizplus · Accepted Answer

$\begin{array}{lcll}
{\text { Applicable to Both Firms }} & {\text { Firm HD's Data }} & \text { Firm LD's Data } \
\text { Assets } & \$ 200 \text { Debt ratio } & 50 \% \text { Debt ratio } & 30 \% \
\text { EBIT } & \$ 40 \text { Interest rate } & 12 \% \text { Interest rate } & 10 \% \
\text { Tax rate } & 35 \% & &
\end{array}$ 
 $\begin{array}{lrr}
\text { Debt }= & \$ 100.0 & \$ 60.0 \
\text { Interest }=\mathrm{I}= & \$ 12.0 & \$ 6.0 \
\text { Taxable income }=\mathrm{EBIT}-\mathrm{I}= & \$ 28.0 & \$ 34.0 \
\mathrm{NI}=(\text { Taxable Income) }(1-\mathrm{T})= & \$ 18.2 & \$ 22.1 \
\text { Equity }=\mathrm{A}-\text { Debt }= & \$ 100.0 & \$ 140.0 \
\mathrm{ROE}=\text { NI/Equity }= & 18.20 \% & 15.79 \%\
\text { Difference in } \mathrm{RO}\mathrm{Es}_{\mathrm{}}=2.41 \%
\end{array}$

Firms HD and LD Are Identical Except for Their Level