  Home Study tools

 My courses
 My books My folder Career Life 

Find solutions for your homework Search

home / study / business / finance / finance questions and answers / suppose firms a and b have the same amount of assets, pay the same interest…

Post a question
Question: Suppose Firms A and B have the same amount of assets, pay …
Answers from our experts for your tough
homework questions
(2 bookmarks)
Suppose Firms A and B have the same amount of assets, pay the
same interest rate on their debt, have the Enter question
same basic earning power
(BEP), and have the same tax rate. However, Firm A has a higher
debt ratio. If
BEP is greater than the interest rate on debt, Firm
A will have a higher ROE as a result of its higher debt
ratio.

Is it true? Please, explain in a VERY DETAILED

way. Continue to post
1 question remaining

Expert Answer

Bhawna answered this

My Textbook Solutions
Was this answer helpful? 5 0
7,663 answers

Answer: Yes,it is True.

The easiest way to think about this is to realize that you can
borrow at a cost of 10% and invest the
proceeds to earn 11%, you’ll
earn a surplus. If you were previously earning an ROE of 10%, then
after
raising and investing additional funds, your income will be
higher, your equity will be the same, and thus
your ROE will
increase. Similarly, if a firm earns more on assets than the
interest rate, there will be a surplus Fundament... Basic... Engineering...
after paying interest on the
debt that will go to the equity, thus increasing the ROE. So, if
BEP > rd, then
6th Edition 5th Edition 8th Edition
the firm can increase its expected ROE by using
more debt leverage.
View all solutions
The answer can also be seen by working out an example. The one
below shows that leverage increases
ROE if BEP > rd, but it
could be varied to show no difference in ROE if interest rates and
BEP are the same,
and a reduction in ROE if the interest rate
exceeds the BEP.

Firm A Firm B

Assets 100% Assets 100%

Debt 60% Debt 0%

Equity 40% Equity 100%

BEP 15% BEP 15%

Interest rate,rd 10% Interest rate,rd 10%

Tax rate 40% Tax rate 40%

EBIT=BEP*Assets 15 EBIT=BEP*Assets 15

Interest 6 Interest 0

Taxable income 9 Taxable income 15

Taxes 3.6 Taxes 6

NI 5.4 NI 9

ROE 13.50% ROE 9%

Comment


Questions viewed by other students

Q: Suppose Firms A and B have the same amount of assets, pay the
same interest rate on their debt, have the same
basic earning power
(BEP), and have the same tax rate. However, Firm A has a higher
debt ratio. If BEP is greater
than the interest rate on debt, Will
firm A have a higher ROE as a result of its higher debt ratio?
Why?

A: See answer

Q: 5. Read the following case and answer the question that follows. If the CEO of a large, diversified, firm were filling out
a fitness report on a division manager (i.e., "grading" the manager), which of the following situations would be likely
to cause the manager to receive a better grade? In all cases, assume that other things are held constant. Justify your
response. a. The...

A: See answer 100% (7 ratings)

Show more 
  Home Study tools
 My courses
 My books My folder Career Life 

COMPANY

LEGAL & POLICIES

CHEGG PRODUCTS AND SERVICES

CHEGG NETWORK

CUSTOMER SERVICE

© 2003-2021 Chegg Inc. All rights reserved.