Question

Leverage, taxes, and ratios Companies Heidee and Leaudy have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT?

a. Company Heidee has more net income.
b. Company Heidee pays less in taxes.
c. Company Heidee has a lower equity multiplier.
d. Company Heidee has a higher ROA.
e. Company Heidee has a higher times interest earned (TIE) ratio.

Answer 1

Answer:

Heidee and Leaudy

The CORRECT statement is:

b. Company Heidee pays less in taxes.

Explanation:

Before Heidee or Leaudy pays taxes, the interest expense will be deducted from the income before taxes.  As Heidee has higher leverage than Leaudy, the amount of income tax expense that Heidee will pay to the IRS will be less than Leaudy's.  Again, since Heidee has a higher leverage than Leaudy, it is likely to have a higher equity multiplier, which is the ratio of the total assets by equity.  Similarly, Leaudy and not Heidee will likely have higher ROA and TIE ratios.