Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' returns on investors' capital (ROIC) exceed their after-tax costs of debt, rd(1 - T). Which of the following statements is CORRECT?
A) HD should have a higher return on assets (ROA) than LD.
B) HD should have a higher times interest earned (TIE) ratio than LD.
C) HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
D) Given that ROIC rd(1 - T), HD's stock price must exceed that of LD.
E) Given that ROIC rd(1 - T), LD's stock price must exceed that of HD.

Question

Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' returns on investors' capital (ROIC) exceed their after-tax costs of debt, rd(1 - T). Which of the following statements is CORRECT?
A) HD should have a higher return on assets (ROA) than LD.
B) HD should have a higher times interest earned (TIE) ratio than LD.
C) HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
D) Given that ROIC > rd(1 - T), HD's stock price must exceed that of LD.
E) Given that ROIC > rd(1 - T), LD's stock price must exceed that of HD.

Quizplus · Accepted Answer

Since both companies have the same business risk, operating income, and tax rate, their ROICs must also be the same since ROIC is based on these factors. However, HD has a higher debt ratio, which means it has a higher financial risk. To compensate for this risk, HD's cost of equity will be higher than LD's, which means HD's ROE will also be higher. However, HD's higher financial risk will also cause its standard deviation of ROE to be higher than LD's. Therefore, C is the correct choice.

Companies HD and LD Have the Same Total Assets, Total