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)rd. 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) rd, hd's stock price must exceed that of ld.
D) given that roic (1-t) rd, 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)rd. 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) rd, hd's stock price must exceed that of ld.
D) given that roic > (1-t) rd, 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 than LD, it will have a higher financial leverage, which will amplify its return on equity (ROE) compared to LD. However, the higher debt ratio also means that HD's risk, as measured by the standard deviation of ROE, will also be higher than LD's.

Choice A is incorrect because the Times Interest Earned (TIE) ratio is not dependent on the debt ratio but the level of EBIT and interest payments.

Choice C and D are incorrect because ROIC exceeding after-tax cost of debt does not solely determine the stock price. Other factors such as growth prospects and market conditions also influence stock prices.

Choice E is incorrect because ROA is not dependent on the debt-equity mix of the companies, but on their operating performance.

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