Question

Which of the following statements is CORRECT? a. If two firms differ only in their use of debt-i.e., they have identical assets, sales, operating costs, and tax rates-but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales. b. A firm's use of debt will have no effect on its profit margin on sales. c. The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable. d. If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses. e. If two firms differ only in their use of debt-i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates-but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales.

Answer 1

Answer:

E) If two firms differ only in their use of debt-i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates-but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales.

Explanation:

Firms that are highly leveraged, i.e. have a lot of debt, have higher costs due to interests that must be paid, so their profit margins are smaller, and their return on assets is also lower, and their risk is much higher also.

But the benefit is that the return on equity is much higher. A greater amount of debt means lower amount of equity, so any profits made must be divided by a smaller amount of stocks or smaller amount of capital invested.