Question

Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt. HD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs?Applicable to Both Firms Firm HD Firm LDAssets $200: EBIT $40: Debt Ratio: 50% 30%Interest Rate: 12% 10%Tax Rate 35%:

Answer 1

Answer:

Firms HD has higher ROE than firm LD.

In details, LD's ROE = 15.79%; HD's ROE = 18.20%. So the difference between LD's ROE and HD's ROE is (2.41%) with LD has lower ratio.

Explanation:

*For firm HD:

Value of debt = 200 * 50% = 100; Value of equity = 200 - 100 = 100.  

Interest expenses = 100 * 12% = $12 => EBT = 40 -12 = $28

Net income = EBT*(1 - tax rate) = 28 * (1-35%) = $18.2

ROE = net income / equity = 18.2 / 100 = 18.2% .

*For firm LD:

Value of debt = 200 * 30% = 60; Value of equity = 200 - 60 = 140.

Interest expenses = 60 * 10% = $6 => EBT = 40 -6 = $34

Net income = EBT*(1 - tax rate)  = 34 * (1-35%) = $22.1

ROE = net income / equity = 22.1 / 140 = 15.79%