Firms U and L each have the same amount of assets, investor-supplied capital, an
ID: 2556053 • Letter: F
Question
Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors' capital (ROIC) of 12%. 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 an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which of the following statements is CORRECT?
The two companies have the same times interest earned (TIE) ratio.
Firm L has a lower ROA than Firm U.
Firm L has a lower ROE than Firm U.
Firm L has the higher times interest earned (TIE) ratio.
Firm L has a higher EBIT than Firm U.
The two companies have the same times interest earned (TIE) ratio.
Firm L has a lower ROA than Firm U.
Firm L has a lower ROE than Firm U.
Firm L has the higher times interest earned (TIE) ratio.
Firm L has a higher EBIT than Firm U.
Explanation / Answer
Answer
b. Firm L has a lower ROA than Firm U.
Explanation: Return on assets (ROA) is generally calculated as
=Net income in a given period / total value of assets
Net income of Firm L will be lower than Firm U because Firm L has to pay interest expense of 8% on debts borrowed. While Firm U does not has interest expense because of 100% equity financing. So, as Firm L has lower net income, its ROA will be lower than Firm U.
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