Firms HD and LD Are Identical Except for Their Level

question 55

Multiple Choice

Firms HD and LD are identical except for their level of debt and the interest rates they pay on debtσHD 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?
$\begin{array}{lcll}{\text { Applicable to Both Firms }} & {\text { Firm HD's Data }} & \text { Firm LD's Data } \\\text { Assets } & \$ 200 \text { Debt ratio } & 50 \% \text { Debt ratio } & 30 \% \\\text { EBIT } & \$ 40 \text { Interest rate } & 12 \% \text { Interest rate } & 10 \% \\\text { Tax rate } & 35 \% & &\end{array}$

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

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Definitions:

Interest Rates

The price paid by a borrower to a lender for accessing assets, depicted as a proportion of the initial amount.

Purchasing Power Parity

Purchasing power parity (PPP) is an economic theory that compares different countries' currencies through a "basket of goods" approach, suggesting that exchange rates should adjust so that identical goods cost the same in different countries.

Interest Rate Parity

A theory which suggests that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies.

Approximation Formula

A mathematical equation or expression used to estimate a value or to simplify calculations.