Companies HD and LD have identical amounts of assets,investor-supplied capital,operating income (EBIT),tax rates,and business risk.Company HD,however,has a higher debt ratio than LD.Company HD's return on investors' capital (ROIC)exceeds its after-tax cost of debt,r_d(1 - T).Which of the following statements is CORRECT? A) Company HD has a higher return on assets (ROA)than Company LD. B) Company HD has a higher times interest earned (TIE)ratio than Company LD. C) Company HD has a higher return on equity (ROE)than Company LD,and its risk as measured by the standard deviation of ROE is also higher than LD's. D) The two companies have the same ROE. E) Company HD's ROE would be higher if it had no debt.

Question

Quizplus · Accepted Answer

Since both companies have the same operating income, tax rate, and business risk, the difference in their debt ratios will result in a difference in their return on equity (ROE). Due to the higher debt ratio, Company HD has a higher financial leverage which increases its ROE. However, the higher debt also increases its risk as measured by the standard deviation of ROE. Therefore, statement (C) is correct. Statements (A) and (B) are incorrect because there is no information provided about the companies' ROA or TIE ratios. Statement (D) is incorrect because the ROE is different between the two companies. Statement (E) is incorrect because removing all debt would result in a lower ROE due to the absence of leverage.

Companies HD and LD Have Identical Amounts of Assets,investor-Supplied Capital,operating