Suppose Firms A and B 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, Firm A has a higher debt ratio. If BEP is GREATER than the interest rate on debt, Firm A will have a HIGHER ROE as a result of its higher debt ratio.

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Quizplus · Accepted Answer

This is because Firm A has a higher leverage ratio, which means it is financing more of its assets with debt. As long as its BEP is greater than the interest rate on its debt, the additional debt will amplify its return on equity (ROE). However, if BEP is less than the interest rate on debt, the additional debt will depress its ROE.

Suppose Firms a and B Have the Same Amount of Assets