Question

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $24 million in invested capital, has $6 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 60% and pays 11% interest on its debt, whereas LL has a 20% debt-to-capital ratio and pays only 8% interest on its debt. Neither firm uses preferred stock in its capital structure.

1. Calculate the return on invested capital (ROIC) for each firm. Round your answers to two decimal places.
   
   ROIC for firm LL is   %
   ROIC for firm HL is   %
2. 
   
3. Calculate the rate of return on equity (ROE) for each firm. Round your answers to two decimal places.
   
   ROE for firm LL is    %
   ROE for firm HL is    %
4. 
   
5. Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 20% to 60% even though that would increase LL's interest rate on all debt to 15%. Calculate the new ROE for LL. Round your answer to two decimal places.
   
   %

Answer 1

We can calculate the desired results as follows:

a) ROIC is calculated as follows:

= Net operating profit after tax / Invested capital

Invested Capital and EBIT of Firm HL and LL are same at $ 24 Million & $ 6 Million

Net operating profit after tax = EBIT * (1 - Tax rate)

= 6 million * (1 - 0.40)

= 6 million * 0.60

= 3.60 million

ROIC = (3.60 / 24)

= 0.15 or 15%

ROIC is same for both the companies HL & LL that is 15% as EBIT and invested capital of both the companies is same and tax rate is also the same.

(b) ROE is calculated as below:

Debt to Capital ratio of HL = 60%

Debt of HL = 60% & Equity of HL = 40%

Debt to Capital ratio of LL = 20%

Debt of LL = 20% & Equity of LL = 80%

Equity of Firm HL = 40% * 24 = $ 9.6 Million & Debt = $ 14.40 Million

Equity of Firm LL = 80% * 24 = $ 19.2 Million & Debt = $ 4.80 Million

ROE = Return available for equity shareholders / Equity capital

Return for equity shareholders = ( EBIT - interst) * (1 - tax rate)

Return for equity shareholders of HL is :

= (6 - (14.40 * 11%)) * (1 - 40%)

= (6 - 1.584) * 0.60

= $ 2.6496 Million

ROE of HL = 2.6496 / 9.6 = 27.60%

Return for equity shareholders of LL is :

= (6 - (4.80 * 8%)) * (1 - 40%)

= (6 - 0.352) * 0.60

= $ 3.3888 Million

ROE of LL = 3.3888 / 19.20 = 17.65%

c) New ROE of LL

= (6 - (14.40 * 15%)) * (1 - 40%)

= (6 - 2.16) * 0.60

= $ 2.304

New Equity capital of LL = 40% of 24 million= $ 9.6 million

New ROE of LL = 2.304 / 9.60 = 24 %

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