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, identical total invested capital, sales, operating costs, interest rates on their debt, and tax rates—but one firm has a higher total debt to total capital ratio, the firm that uses more debt will have a lower profit margin on sales and a lower return on assets. b. The total debt to total capital 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. c. A firm's use of debt will have no effect on its profit margin. d. If two firms differ only in their use of debt—i.e., they have identical assets, identical total invested capital, operating costs, and tax rates—but one firm has a higher total debt to total capital ratio, the firm that uses more debt will have a higher operating margin and return on assets. e. If one firm has a higher total debt to total capital ratio than another, we can be certain that the firm with the higher total debt to total capital ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses.

Answer 1

Answer: a. If two firms differ only in their use of debt—i.e., they have identical assets, identical total invested capital, sales, operating costs, interest rates on their debt, and tax rates—but one firm has a higher total debt to total capital ratio, the firm that uses more debt will have a lower profit margin on sales and a lower return on assets.

Explanation:

A firm that uses more debt financing will have to pay more interest. Interest is an expense that is deducted from Net Income so the more the debt, the higher the interest payment and the lower the net profit/ income.

Profit margin on sales is calculated by dividing profit by the sales revenue and  return on assets is calculated by dividing net income by the average total assets. Both these ratios use the Net income as the numerator so if it is lower as a result of more interest payments, the ratio will be lower as well.