Companies HD and LD have identical amounts of assets, operating income (EBIT), t

Question

Companies HD and LD have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD's basic earning power ratio (BEP) exceeds its cost of debt (r). 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.

Explanation / Answer

c. Company HD has a higher return on equity (ROE) than Company LD, and its risk, as measured by the standard deviation of ROE, i also higher than LD's. Because of the debt interest tax shield, HD has a higher return on equity. Also due to high leverage, the company will be much riskier than LD.

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