Question

Company AA and Company BB have identical Assets, Revenues and Ebit. They are in the same line of business. Company AA has a Debt/Capital ratio of 0, while Company BB's ratio is 75%. Company BB pays a low interest rate, and both company's pay the same income tax rate. During good, profitable years, which company probably has the highest Net Income and why

Answer 1

Company BB likely has a higher net income in good years due to the tax benefits of its interest payments on debt, despite identical operations and revenue to Company AA.

Step-by-step explanation:

The question pertains to the impact of leverage on net income in profitable years for two companies, AA and BB, which operate under identical conditions except for their debt structures. Company AA has no debt (Debt/Capital ratio of 0), whereas Company BB has a high level of debt (Debt/Capital ratio of 75%). During profitable years, Company BB, despite incurring interest expenses, is likely to have a higher net income due to the tax shield provided by interest payments. The interest expense is deductible before taxes, which reduces BB's taxable income, and assuming they both pay the same income tax rate, BB will end up with a higher net income after tax due to this advantage. This concept is related to the modigliani-Miller theorem on capital structure, which suggests that under certain circumstances, a firm's value is unaffected by its capital structure, but can be impacted by tax advantages of debt.