Firms HD and LD Are Identical Except for Their Level

question 69

Multiple Choice

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?
$$\begin{array} { | c | c | c | } \hline & \text { Firm HD } & \text { Firm LD } \\\hline \text { Assets } & 200 & 200 \\\hline \text { Debt } & 100 & 60 \\\hline \text { Equity } & 100 & 140 \\\hline & & \\\hline \text { EBIT } & 40 & 40 \\\hline \text { Interest } & 12 & 6 \\\hline \text { EBT } & 28 & 34 \\\hline \text { Taxes } & 7 & 8.5 \\\hline \text { Net income } & 21 & 25.5 \\\hline \text { ROE } & 21.00 \% & 18.21 \% \\\hline\end{array}$$

• A)2.18%
• B)2.29%
• C)2.41%
• D)2.54%
• E)2.66%

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Definitions:

Risk-Free Asset

An asset that supposedly carries no risk of financial loss and is expected to return its full value along with known interest or dividends.

Risky Asset

A financial instrument whose future returns are uncertain and subject to a wide variety of outcomes.

Capital Allocation Line

A graphical representation used in finance to show possible rates of return for portfolios with different levels of risk.

Lending Rate

The interest rate charged by banks on loans extended to clients.