Two operationally similar companies, HD and LD, have identical amounts of assets, operating income (EBIT), tax rates, and business risk.Company HD, however, has a much higher debt ratio than LD.Company HD's basic earning power ratio (BEP)exceeds its cost of debt (rd).Which of the following statements is CORRECT?

Question

Quizplus · Accepted Answer

Since both companies have identical amounts of assets, operating income (EBIT), tax rates, and business risk, the difference in their BEP ratios is due to their different debt ratios. Therefore, HD's higher BEP ratio coupled with its lower cost of debt suggests that it has a higher return on equity (ROE) than LD. However, this comes at the cost of a higher risk, as measured by the standard deviation of ROE. The other statements are incorrect: 
A) We cannot determine the TIE ratio based on the information provided.
C) The two companies have different debt ratios and hence different financial structures, which will affect their ROE.
D) This is not necessarily true. HD's ROE may decrease due to the cost of equity increasing as a result of having no debt.
E) We cannot determine the ROA based on the information provided.

Two Operationally Similar Companies, HD and LD, Have Identical Amounts