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.
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A. B. C. D.D
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.