Question

1. Debt Corporation is financed with 50 percent debt, while equity Corporation has the same amount of total assets, but is financed entirely with equity. Both Corporation have a marginal tax rate of 40 percent. Which of the following statements is most correct.

   1. If the two corporations have the same return on assets, Equity Corporation will have a higher return on equity.

   2. If the two corporations have the same basic earning power (BEP), Equity Corporation will have a higher return on assets.

   3. If the two corporations have the same level of sales and basic earning power, Equity Corporations will have a lower net profit margin.

   4. All of the answers above are correct.

   5. None of the answers above are correct.

Can you also explain why?

Answer 1

Answer:

Correct answer is:

If the two corporations have the same basic earning power (BEP), Equity Corporation will have a higher return on assets.

Explanation:

Statement 1 is incorrect. If both corporations have the same return on assets, equity corporation having a higher a equity base will have lower return on equity.

Statement 2:

Let us take an example:

Total assets =$5,000

Sales = $10,000

EBIT = $2,000

Interest rate on debt = 10%

In the above example both corporation have same earning power. Debt corporation has to deduct interest expenses and as such due to effect of interest charges net of tax, will have lower net income as compared to net income of Equity corporation. As such Equity corporation will have higher return on assets.

In above example:

ROA of Debt corporation = 1050 / 5000 = 21%

ROA of Equity corporation = 1200 / 5000 = 24%

As such If the two corporations have the same basic earning power (BEP), Equity Corporation will have a higher return on assets.

This statement is correct.

Statement 3 and 4 (based on above comments) are incorrect.