Firms U and L each have the same amount of assets, and both have a basic earning power ratio of...

Question:

Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has a before-tax cost of 8%. Both firms have positive net income. Which of the following statements is CORRECT?

a) The two companies have the same times interest earned (TIE) ratio.

b) Firm L has a lower ROA than Firm U.

c) Firm L has a lower ROE than Firm U.

d) Firm L has the higher times interest earned (TIE) ratio.

e) Firm L has a higher EBIT than Firm U.

Capital Structure Dynamics:

This question requires a basic understanding of a firm's capital structure. A capital structure is the strategic combination of debt and equity used by an organization to finance its operations. Capital structures can vary widely. Firms with a high debt ratio (debt/assets) are generally considered to be riskier, while firms with a low debt ratio can find it difficult to generate adequate rates of return for their shareholders.

Answer and Explanation:

The correct answer is "b) Firm L has a lower ROA than Firm U." Given the same amount of assets and the same EBIT (known since the firms also have the same earning power ratio, which is EBIT/assets), Firm L must have a lower ROA, because is pays interest expense on debt, whereas Firm U does not.

The other responses are incorrect for the following reasons:

- a) Firm U has no debt and pays no interest. So, the TIE ratio doesn't even apply to it.

- c) Firm L has a higher ROE than Firm U. We know this, because Firm L has much less equity than Firm U, and its earning power ratio is higher than its cost of debt, which means the leverage is accretive to its ROA.

- d) Firm U has no debt and pays no interest. So, the TIE ratio doesn't even apply to it.

- e) We know the firms have the same EBIT, as explained above.


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Capital Structure & the Cost of Capital

from Finance 101: Principles of Finance

Chapter 15 / Lesson 1
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