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 basic earning power (BEP)exceeds its cost of debt (rd).Which of the following statements is CORRECT?

Question

Quizplus · Accepted Answer

Since HD has a higher debt ratio, it is more levered and thus has higher financial risk. However, if HD's BEP exceeds its cost of debt, it means that its operating income is sufficient to cover both its operating and financing costs. This implies that HD has a higher return on equity (ROE) than LD, as it uses more debt financing to boost profits, but its risk, as measured by the standard deviation of ROE, will also be higher due to the additional financial leverage. Hence, option B is the best choice. Option A is incorrect as TIE ratio is not related to the debt ratio, but rather the interest coverage ratio. Option C and D are incorrect as the stock price reflects the firm's future earnings growth potential and is not related to BEP. Option E is also incorrect as ROA is not affected by debt financing but only by the profitability of the firm's operations.

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