Companies HD and LD have the same total assets, total investor-supplied capital,
ID: 2793304 • Letter: C
Question
Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' returns on investors' capital (ROIC) exceed their after-tax costs of debt, rd(1 – T). Which of the following statements is CORRECT?
a. Given that ROIC > rd(1 – T), LD's stock price must exceed that of HD. b. HD should have a higher times interest earned (TIE) ratio than LD. c. Given that ROIC > rd(1 – T), HD's stock price must exceed that of LD. d. HD should have a higher return on assets (ROA) than LD. e. 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.Explanation / Answer
a.) False. Since HD has higher debt than LD so the stock price of HD will be higher. EBIT is same for both companies. Total invester supplied capital is also same. The proportionate amount of decrease in shareholder's equity for HD is more that the decrease in Net Income as compared to LD.
b.) False. TIE ratio is EBIT divided by total interest payable. Interest payable for HD is higher so TIE ration should be lower for HD as compared to LD.
c.) True. Since HD has higher debt than LD so the stock price of HD will be higher. EBIT is same for both companies.Total invester supplied capital is also same. The proportionate amount of decrease in shareholder's equity for HD is more that the decrease in Net Income as compared to LD.
d.) False. ROA is Net Income divided by Total Assets. Total Assets is same for both the companies. Net Income for HD wil be lower because of additional interest expense which has to be borne by LD.
e.) True. Return of equity for HD will be higher during profitable periods. It is like a double edged sword. During boom period profits will be more and during recession, losses will be also more. Since in question it is given that ROIC is more than rd (1-T) so we are infering that profit is greater than 0. Also with increase in debt for a company we can infer that the standard deviation of ROE increases.
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