Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt--HD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs? Applicable to Both Firms Firm HD's Data Firm LD's Data
Assets $200 Debt ratio 50% Debt ratio 30%
EBIT $40 Interest rate 12% Interest rate 10%
Tax rate 35%
A) 2.18%
B) 2.29%
C) 2.41%
D) 2.54%
E) 2.66%

Question

Quizplus · Accepted Answer

To find the difference in ROEs, calculate ROE for each firm. For HD: Debt = $100, Interest = $12, EBT = $28, Net Income = $18.2, Equity = $100, ROE = 18.2%. For LD: Debt = $60, Interest = $6, EBT = $34, Net Income = $22.1, Equity = $140, ROE = 15.79%. Difference = 18.2% - 15.79% = 2.41%.

Firms HD and LD Are Identical Except for Their Level