question archive Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk
Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk
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Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A's basic earning power (BEP) exceeds its cost of debt financing (r.). Which of the following statements is most correct?
a. Company A has a higher retum on assets (ROA) than Company B.
b. Company A has a higher times interest eamed (TIE) ratio than Company B.
c. Company A has a higher return on equity (ROE) than Company B, and its risk, as mcasured by the standard deviation of ROE, is also higher than Company B's
d. Statements b and c are correct.
e. All of the statements above are correct.
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Answer:
c. Company A has a higher return on equity ( ROE ) than Company B, and its risk, as measured by the standard deviattion of ROE, is also higher than Company B's.
As per the Du Pont equation,
ROE = Return on Assets x Equity Multiplier
A larger proportion of the assets of Company A is financed by debt, as compared to Company B. As the equity multiplier ( Total Assets / Equity ) of Company A is greater than that of Company B, its ROE is higher as also the risk.
