Question

Companies HD and LD have identical tax rates, total assets, total investor-supplied capital, and returns on investors' capital (ROIC), and their ROICs exceed their after-tax costs of debt, rd(1 - T). However, Company HD has a higher debt ratio and thus more interest expense than Company L. Which of the following statements is CORRECT?

(a) Company HD has a higher net income than Company LD.
(b) Company HD has a lower ROA than Company LD
(c) Company HD has a lower ROE than Company LD.
(d) The two companies have the same ROA.
(e) The two companies have the same ROE.

Answer 1

B

Step-by-step explanation:

Only B appears plausible.

Higher debt means higher interest costs, which would lead to lower net income.

ROA = Net Income / Assets and ROE = Net Income / Equity

Now, assets are same, equity is different. Equity for HD will be lower while that for LD would be higher. Hence, predicting ROE is difficult as we don't know equity but ROA is a bit easier.