Lottadoe and Bigbux are two companies that are identical in every respect except that Lottadoe uses only equity financing while Bigbux relies heavily on debt financing. Over the past year, the firms had identical net incomes before interest and taxes were taken into account. If this net income was very high, what would it mean for Bigbux?
A) Bigbux would report a higher return on equity than Lottadoe.
B) Bigbux would report a lower return on equity than Lottadoe.
C) Lottadoe would pay less in taxes than Bigbux.
D) Lottadoe would report a lower net income after taxes than Bigbux.

Question

Quizplus · Accepted Answer

Bigbux, which uses debt financing, would have to pay interest on its debt. This interest payment is tax-deductible, effectively reducing the company's taxable income. Given a very high net income before interest and taxes, after paying interest, Bigbux would still have a substantial net income but with a lower tax liability compared to Lottadoe, which does not have this interest expense. Consequently, Bigbux's use of leverage (debt financing) would amplify its return on equity compared to Lottadoe, which relies solely on equity financing. This is because the return on equity formula considers net income and shareholders' equity, and Bigbux's strategy would lead to a higher net income relative to its equity due to the tax savings and leveraging effect.

Lottadoe and Bigbux Are Two Companies That Are Identical in Every