Companies HD and LD have the same total assets, operating income (EBIT), tax rat

Question

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).

Who can explain why answer C is correct, or why any other responses are incorrect?

A HD should have a higher return on assets (ROA) than LD.
B HD should have a higher times interest earned (TIE) ratio than LD.
C HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
D Given that BEP is greater than rd, HD's stock price must exceed that of LD.

E Given that BEP is greater than rd, LD's stock price must exceed that of HD

Explanation / Answer

1. b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company

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