Question

Two companies, A and B, both have $1 million in assets, earnings before interest and taxes (EBIT) of $160,000, and the same tax rate. Company A is all equity financed, and Company B is 50% debt financed and 50% equity financed. If Company B's pretax cost of debt is 8%, then Company A will have a ROA that is _____ and a ROE that is _____ than Company B's. a. Option D b. Option B c. Option A d. Option C

Answer 1

Question Completion with Options:

A) lower, higher

B) higher, higher

C) lower, lower

D) higher, lower

Answer:

Companies A and B

If Company B's pretax cost of debt is 8%, then Company A will have a ROA that is __higher___ and a ROE that is __lower___ than Company B's.

a. Option D

Step-by-step explanation:

a) Data and Calculations:

Company A Company B

Assets $1,000,000 $1,000,000

EBIT 160,000 160,000

Tax rate = same

Equity 100% 50%

Debts 0% 50%

Equity $1,000,000 $500,000

Debts $0 $500,000

Pretax cost of debt 0% 8%

Interest expense $0 $40,000

Pretax income $160,000 $120,000

ROA (Return on assets) = Pretax income/Assets * 100

= 16% 12%

ROE (Return on equity) = Pretax income/Equity * 100

= 16% 24%