94 Part 2 Fundamental Concepts in Financial Management
good conditions down to $0 under bad conditions. When U’s net income is di-
vided by its common equity, its ROEs range from 27% to 0% depending on the
state of the economy.
Firm L has the same EBIT as U under each state of the economy, but L uses $50
of debt with a 10% interest rate; so it has $5 of interest charges regardless of the
economy. This $5 is deducted from EBIT to arrive at taxable income; taxes are
taken out; and the result is net income, which ranges from $24 to "$5 depending
on conditions.^10 At! rst, it looks as though Firm U is better off under all condi-
tions; but this is not correct—we need to consider how much the two! rms’ stock-
holders have invested. Firm L’s stockholders have put up only $50; so when that
investment is divided into net income, we see that their ROE under good condi-
tions is a whopping 48% (versus 27% for U) and is 12% (versus 9% for U) under
expected conditions. However, L’s ROE falls to "10% under bad conditions,
which means that Firm L would go bankrupt if those conditions persisted for
several years.
There are two reasons for the leveraging effect: (1) Interest is deductible, so the
use of debt lowers the tax bill and leaves more of the! rm’s operating income avail-
able to its investors. (2) If the rate of return on assets exceeds the interest rate on
debt, as is generally expected, a company can use debt to acquire assets, pay the in-
terest on the debt, and have something left over as a “bonus” for its stockholders.
Under the expected conditions, our hypothetical! rms expect to earn 15% on assets
versus a 10% cost of debt. This, combined with the tax bene! t of debt, pushes L’s
expected ROE far above that of U.
Thus,! rms with relatively high debt ratios typically have higher expected
returns when the economy is normal but lower returns and possibly bankruptcy if
the economy goes into a recession. Therefore, decisions about the use of debt re-
quire! rms to balance higher expected returns against increased risk. Determining
the optimal amount of debt is a complicated process, and we defer a discussion of
that subject until the capital structure chapter. For now, we simply look at two pro-
cedures that analysts use to examine the! rm’s debt: (1) They check the balance
sheet to determine the proportion of total funds represented by debt, and (2) they
review the income statement to see the extent to which interest is covered by oper-
ating pro! ts.4-4a Total Debt to Total Assets
The ratio of total debt to total assets, generally called the debt ratio, measures the
percentage of funds provided by creditors:Debt ratio! __________Total debt
Total assets! $310 ____________$ $750
$2,000
! $1,060______
$2,000
! 53.0%Industry average! 40.0%Total debt includes all current liabilities and long-term debt. Creditors prefer low
debt ratios because the lower the ratio, the greater the cushion against creditors’
losses in the event of liquidation. Stockholders, on the other hand, may want more
leverage because it can magnify expected earnings, as we saw in Table 4-1.
Allied’s debt ratio is 53.0%, which means that its creditors have supplied more
than half of its total funds. As we will discuss in the capital structure chapter, aDebt Ratio
The ratio of total debt to
total assets.Debt Ratio
The ratio of total debt to
total assets.(^10) As we discussed in the last chapter,! rms can carry losses back or forward for several years. Therefore, if Firm L
had pro! ts and thus paid taxes in recent 2007, it could carry back the 2008 loss under bad conditions and receive
a credit (a check from the government). In Table 4-1, we disregard the carry-back/carry-forward provision.