Firms U and L both have a basic earning power ratio of 20% and each has the same amount of assets.Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity.Firm L's debt has a before-tax cost of 8%.Both firms have positive net income.Which of the following statements is CORRECT?

Question

Quizplus · Accepted Answer

DFirm L, which is leveraged, can achieve a higher Return on Equity (ROE) than Firm U due to the use of debt, assuming the cost of debt is less than the return on assets (ROA). This is because leveraging amplifies the returns to equity holders when the firm earns more on its investments than the cost of its debt. Since both firms have the same basic earning power (BEP) and the same amount of assets, but Firm L uses debt at a cost of 8% which is lower than their BEP of 20%, leveraging should increase Firm L's ROE compared to Firm U. However, the question does not ask directly about ROE comparisons but provides insights into other financial metrics.A) Firm L has a lower ROA than Firm U. This statement is incorrect because ROA is determined by the firm's operating efficiency and not by how it is financed. Both firms have the same basic earning power and assets, so their ROA should be the same.B) Firm L has a lower ROE than Firm U. This is incorrect because leveraging (using debt) at a cost lower than the return on assets should increase the ROE for Firm L compared to Firm U, which is not leveraged.C) Firm L has the higher times interest earned (TIE) ratio. This is incorrect because the TIE ratio is calculated as EBIT divided by interest expense. Firm L, which has debt, will have to pay interest, reducing its TIE ratio compared to Firm U, which has no debt and thus no interest expense.D) Firm L has a higher EBIT than Firm U. This is correct because both firms have the same basic earning power and the same amount of assets. The basic earning power ratio is EBIT divided by total assets. Since they have the same ratio and the same amount of assets, they should have the same EBIT.E) The two companies have the same times interest earned (TIE) ratio. This is incorrect because Firm L has debt and therefore has interest expenses, which would affect its TIE ratio, unlike Firm U, which has no debt.

Firms U and L Both Have a Basic Earning Power