CFA Practice Question
Two otherwise identical firms, A and B, have one difference. A has a higher interest expense than B, arising from its higher reliance on debt financing. All other accounting statistics, including net sales and expenses are equal for the two firms. The return on total capital for firm A will be ______ that for firm B.
A. lower than
B. higher than
C. the same as
Explanation: The return on total capital equals the net income before interest expense as a fraction of the average total capital invested. Therefore, if interest expenses were not tax deductible, the two firms would have exactly the same return on total capital. However, due to tax advantages of interest expenses, firm A will show a higher net income and hence, a higher return on capital.
User Contributed Comments 13
| User | Comment |
|---|---|
| shasha | ROC = (NI+Int)/atc |
| danlan | ROC is ROA and not ROE |
| armanaziz | So, It is Net Income before Interest, but after tax? |
| sivenkova | Isn't the denominator logically increased as well? |
| Janey | ROC = NI + Interest Expense / Debt + Equity |
| dbadidas8 | Leverage (with all things equal) will equate to greater return on capital |
| kevinf12 | Why wouldnt A have to earn greater than the cost of Debt for this to be true? Ahhhh....ROIC....no interest exp. |
| rgat | Vol4 pg 598 ROC = EBIT /(Total_D+Total_E) So, Firm A=higher Int Exp->lower Net Inc->lower Equity->lower denominator->higher ROC |
| Gooner7 | nice rgat |
| andrewmorgan | lower net inc does not necessarily mean lower equity as we dont know what the dividends were. ROTC is EBIT over capital, EBIT is unchanged so this question is a bit dodgy |
| mc42086 | what if net income is negative!? |
| harrybay | This doesn't work. Firm A has to pay interests. Even if these interests are tax deductible they still have to pay Interest(1-taxrate) whereas Firm B doesn't pay anything. The last sentence which states that Firm A will show higher net income is completely fallacious. In addition, the point of calculating ROC is to neutralize any effect of leverage. If the formula is really EBIT/Total Capital, then both firms should have the same exact ROC. Don't know who wrote those questions but clearly doesn't know much about finance. |
| merc5559 | They say the ratio consists of net income before taxes but then use the tax savings as the reason why one ratio should be higher?? |