Companies HD and LD have identical amounts of assets, investor-supplied capital, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD's return on investors' capital (ROIC) exceeds its after-tax cost of debt, rd(1 - T). Which of the following statements is CORRECT?
A) Company HD has a higher return on assets (ROA) than Company LD.
B) Company HD has a higher times interest earned (TIE) ratio than Company LD.
C) Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD's.
D) The two companies have the same ROE.
E) Company HD's ROE would be higher if it had no debt.

Question

Quizplus · Accepted Answer

Since both companies have identical amounts of assets, investor-supplied capital, operating income (EBIT), tax rates, and business risk, the difference in their ROIC must be due to their capital structure. Company HD's higher debt ratio results in a higher ROIC than LD's as long as its after-tax cost of debt is lower than the ROA. However, the higher financial leverage also results in higher risk, as measured by the standard deviation of ROE. Therefore, option C is correct. Option A is incorrect because ROA is not affected by capital structure. Option B is incorrect because TIE is affected by the level of debt but not the ROIC. Option D is incorrect because the return on equity (ROE) is affected by capital structure, so HD's higher debt ratio should result in a higher ROE, assuming all else is equal. Option E is incorrect because HD's ROE would not necessarily be higher without debt. The higher financial leverage increases the return to equity investors, but it also increases the risk, which could decrease the stock price and result in a lower ROE.

Companies HD and LD Have Identical Amounts of Assets, Investor-Supplied