ExpertHard1 markMultiple Choice
CPA · Question 15 · Area I: Business Analysis
Management is deciding between two financing plans: Plan A (100% Equity) and Plan B (50% Debt, 50% Equity). Plan B involves issuing bonds with a 6% interest rate. The corporate tax rate is 25%. If the company expects its Return on Assets (ROA) to be 10% (before tax), which plan will result in a higher Return on Equity (ROE), and why?
Management is deciding between two financing plans: Plan A (100% Equity) and Plan B (50% Debt, 50% Equity). Plan B involves issuing bonds with a 6% interest rate. The corporate tax rate is 25%. If the company expects its Return on Assets (ROA) to be 10% (before tax), which plan will result in a higher Return on Equity (ROE), and why?
Answer options:
A.
Plan A, because it avoids interest expense.
B.
Plan B, because the Return on Assets (10%) exceeds the after-tax cost of debt (4.5%).
C.
Plan A, because financial leverage always increases risk without guaranteeing returns.
D.
Plan B, because the interest tax shield increases Net Income compared to Plan A.
How to approach this question
Compare ROA to the Cost of Debt. If ROA > Cost of Debt, leverage is positive (increases ROE). If ROA < Cost of Debt, leverage is negative (decreases ROE).
Full Answer
B.Plan B, because the Return on Assets (10%) exceeds the after-tax cost of debt (4.5%).✓ Correct
B
Positive financial leverage occurs when the return generated by assets (ROA) exceeds the cost of the debt used to finance them. Here, the company earns 10% on assets but only pays 6% (pre-tax) on debt. The excess return accrues to the shareholders, boosting ROE.
Common mistakes
Thinking higher Net Income always means higher ROE (ignoring the smaller equity base in Plan B).
Practice the full CPA BAR Practice Exam 3
50 questions · hints · full answers · grading
More questions from this exam
Q01Orion Manufacturing provides the following financial data for the current year:<br/><br/>- Net Sa...HardQ02A manufacturing company uses a standard cost system. For the month of June, the following data is...MediumQ03A financial analyst is reviewing a company's sales data using a visualization tool. The scatter p...MediumQ04TechStart Inc. reports Net Income of $500,000. The income statement includes:<br/>- Depreciation ...MediumQ05A company produces two products, A and B. Under its traditional costing method, the company alloc...Medium