Question

Two companies, A and B, both have $1 million in assets, earnings before interest and taxes (EBIT) of $160,000, and the same tax rate. Company A is all equity financed, and Company B is 50% debt financed and 50% equity financed. If Company B's pretax cost of debt is 8%, then Company A will have a ROA that is _____ and a ROE that is _____ than Company B's. a. Option D b. Option B c. Option A d. Option C

Answer 1

Question Completion with Options:

A) lower, higher

B) higher, higher

C) lower, lower

D) higher, lower

Answer:

Companies A and B

If Company B's pretax cost of debt is 8%, then Company A will have a ROA that is __higher___ and a ROE that is __lower___ than Company B's.

a. Option D

Explanation:

a) Data and Calculations:

                           Company A       Company B

Assets                 $1,000,000       $1,000,000

EBIT                          160,000            160,000

Tax rate = same

Equity                       100%                 50%

Debts                           0%                 50%

Equity                 $1,000,000         $500,000

Debts                        $0                 $500,000

Pretax cost of debt    0%                   8%

Interest expense     $0                   $40,000

Pretax income      $160,000         $120,000

ROA (Return on assets) = Pretax income/Assets * 100

=                             16%                     12%

ROE (Return on equity) = Pretax income/Equity * 100

=                             16%                    24%