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ROE for Devon and Berwyn: risk, WACC, cost of equity, debt ratio

Devon Inc. has a higher ROE than Berwyn Inc. (17 percent compared to 14 percent), but it has a lower EVA than Berwyn. Which of the following factors could explain the relative performance of these two companies?

a. Devon is much larger than Berwyn.
b. Devon is riskier, has a higher WACC, and a higher cost of equity.
c. Devon has a higher operating income (EBIT).
d. Statements a and b are correct.
e. All of the statements above are correct.

If a company increases its debt ratio, but leaves its operating income (EBIT) and total assets unchanged, which of the following is most likely to occur:

a. The company's tax liability will fall.
b. The company's net income will rise.
c. The company's basic earning power will fall.
d. Answers a and b are correct.
e. None of the answers above is correct.

Solution Preview

1. (B) Devon is riskier, has a higher WACC, and a higher cost of equity.

A higher ROE and a smaller EVA is caused by a higher kS or by a smaller equity or size.

Out of A, B, or C, we can eliminate A because if Devon is larger than Berwyn ...

Solution Summary

The solution provides a good explanation for the two problems including the correct response.

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