Which of the following statements is correct? a) The higher its debt ratio, the

Question

Which of the following statements is correct?

a) The higher its debt ratio, the lower a firm’s BEP ratio will be, other things held constant.
b) If a firm’s expected basic earning power (BEP) is constant for all of its assets and exceeds the interest rate on its debt, then adding assets and financing them with debt will raise the firm’s expected return on common equity (ROE).
c) The higher its tax rate, the lower a firm’s BEP ratio will be, other things held constant.
d) The higher the interest rate on its debt, the lower a firm’s BEP ratio will be, other things held constant.



Why is ratio analysis useful?

a) It’s not useful; nobody in the real world ever uses this stuff.
b) Unlike “raw” accounting data, ratios cannot be distorted by inflation.
c) It eliminates the need to consider “qualitative” factors when evaluating a firm’s financial condition.
d) It is a way of standardizing numbers and can facilitate comparisons between firms.
e) It provides an easy, objective way of telling whether a company is, on balance, in a strong or weak position.

Explanation / Answer

1.c) The higher its tax rate, the lower a firm’s BEP ratio will be, other things held constant.

Earnings earned for equity are not tax deductible and tax has to be paid on such income, and the remaining is distributed to the equity shareholders.

Hence, higher tax rate will lead to lower Basic Earning per Share.

However, if you can select multiple correct statements, Then statement b and d are also correct

b) If a firm’s expected basic earning power (BEP) is constant for all of its assets and exceeds the interest rate on its debt, then adding assets and financing them with debt will raise the firm’s expected return on common equity (ROE).

d) The higher the interest rate on its debt, the lower a firm’s BEP ratio will be, other things held constant.

2.Ratio analysis is useful because:

d) It is a way of standardizing numbers and can facilitate comparisons between firms.

e) It provides an easy, objective way of telling whether a company is, on balance, in a strong or weak position.

b) Unlike “raw” accounting data, ratios cannot be distorted by inflation.

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