Suppose two firms have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate. However, one firm has a higher debt ratio. If BEP is greater than the interest rate on debt, the firm with the higher debt ratio will also have a higher rate of return on common equity.

Question

Quizplus · Accepted Answer

This is because the higher debt ratio firm has a lower amount of equity financing, which means that the profits will be divided among fewer shareholders. This will result in a higher return on equity for the remaining shareholders. However, if BEP is lower than the interest rate on debt, the higher debt ratio firm may face financial distress and a lower return on equity.

Suppose Two Firms Have the Same Amount of Assets, Pay