Companies HD and LD have identical tax rates, total assets, and basic earning po

Question

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?
Answer







Company HD has a higher net income than Company LD.








Company HD has a lower ROA than Company LD.








Company HD has a lower ROE than Company LD.








The two companies have the same ROA.








The two companies have the same ROE.

Explanation / Answer

Given that both the companies have the same tax rates, total assets & basic earnings power ratios.

Since the Company HD has higher debt ratio which leads to high interest payments, naturally the net income for HD will be low.

But given the total assets value for both the companies is the same.

So, if we calculate the ROA ratio, then the Company HD reports less percent of ROA than the Company LD.

Let us assume net income for HD = $25,000
Net income for LD = $30,000
Total assets for both companies = $90,000

ROA for HD = Net income / Total assets
                  = $25,000 / $90,000
                  = 0.2778 or 27.78%

ROA for LD = Net income / Total assets
                 = $30,000 / $90,000
                 = 0.3333 or 33.33%

Therefore, the ROA for HD is less than the ROA for LD.

Hence, the correct option is b)

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