Firms U and L each have the same amount of assets, and both have a basic earning
ID: 2755957 • Letter: F
Question
Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%. 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 a before-tax cost of 8%. Both firms have positive net income. Which of the following statements is CORRECT?
a)The two companies have the same times interest earned (TIE) ratio.
b)Firm L has a lower ROA than Firm U.
c)Firm L has a lower ROE than Firm U.
d)Firm L has the higher times interest earned (TIE) ratio.
e)Firm L has a higher EBIT than Firm U.
Please, provide DETAILED EXPLANATION!
Explanation / Answer
Solution :
calculation of ratios
givenn the conditions, it is evident that firm L will have lower net profits after tax , as it has interest burden @ 8% on debt finance.firm U is unleveraged , hence EBIT & profits after tax will only be impacted by tax amounts, whereas firm L will have interest deduction , which will cause reduced profits liable to tax.
Reurn on assets is calculated as follows
(Profits after tax / interest expenses)
So when firm U calculates ROA , it s definitrely higher than the one that is calculated by firm L, due to higher profits after tax ( due to interest deduction).Hence the correct statemnt would be
b)Firm L has a lower ROA than Firm U.
particulars Firm L firm U Basic earning power 20% 20% equity financed 50% 100% debt financed 50% - before tax debt cost 8% EBIT 100 100 Interest 16 - Earnings liable to tax 84 100 tax @ 30% 25 30 Profits after tax 59 70Related Questions
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