Firms A and B are identical except for their level of debt and the interest rates they pay on debt.

Each has $2 million in assets, $400,000 of EBIT, and has a 40% tax rate. However, firm A has a debt-to-assets ratio of 50% and pays 12% interest on its debt.

While Firm B has a 30% debt ratio and pays only 10% interest on its debt.

Required:

a) Determine the return on equity for each firm.

b) Explain why Firm B pays lower interest.

(Please show your work part-by-part)