Question

Company ABC has a return on assets of 3.2% and a return on equity of 12%. Company XYZ has a return on assets of 3.2% and a return on equity of 18%, What is the likely principal reason for the difference?

A

ABC's equity market price is greater than XYZ equity market price.

B

XYZ has a higher level of leverage than ABC.

C

XYZ's total assets are less than ABC's total assets.

D

ABC's total assets are less than XYZ's total assets.

Answer 1

Option (B) : XYZ has a higher level of leverage than ABC.

Explanation:

~ The difference between the Return on Equity of the two firms is basically due to the capital structures of the firms.

~ The level of leverage taken by a firm tends to increase the ROE because the demniminator gets reduced in the formula to calculate the ROE.

~ The ROE is calculated as = Net Income / Equity

~ Now, keeping other things constant, a firm with a lower Equity will be having a higher ROE as we can see in the above formula.

~ Therefore, since XYZ is having a higher ROE shows that it has been more leveraged than ABC.