In: Finance
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $23 million in invested capital, has $4.6 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 55% and pays 13% interest on its debt, whereas LL has a 35% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure.
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Solution: | |||
a. | ROIC for firm LL is 12.00% | ||
ROIC for firm HL is 12.00% | |||
Working Notes: | |||
Return on invested capital (ROIC ) will be same both of the firm as both have same amount of invested capital, generate same amount of EBIT and are in same tax bracket. | |||
And | |||
Return on invested capital (ROIC ) = EBIT x ( 1 - tax rate)/Invested capital | |||
Return on invested capital (ROIC ) = $4,600,000 x ( 1 - 0.40)/$23,000,000 | |||
Return on invested capital (ROIC ) = 0.12 | |||
Return on invested capital (ROIC ) = 12.00% | |||
b. | ROE for firm LL is 15.23% | ||
ROE for firm HL is 17.13% | |||
Working Notes: | |||
ROE for firm LL is 15.23% | |||
LL firm have 35% debt to capital ratio | |||
Total capital invested is $23,000,000 | |||
Debt 35% $23,000,000 x 35% = $8,050,000 | |||
Equity 65% $23,000,000 x 65% = $14,950,000 | |||
rate of interest on debt is 10% | |||
A | EBIT | $4,600,000 | |
B | Less: Interest | $805,000 | |
[10% x $8,050,000] | |||
C=A-B | EBT | $3,795,000 | |
D | Less: Taxes @ 40% | $1,518,000 | |
[40% x $3,795,000] | |||
E=C-D | EAT | $2,277,000 | |
ROE for firm LL = EAT/Equity | |||
ROE for firm LL = $2,277,000 /$14,950,000 | |||
ROE for firm LL = 0.152307692 | |||
ROE for firm LL = 15.23% | |||
Now HL | ROE for firm HL is 17.13% | ||
HL firm have 55% debt to capital ratio | |||
Total capital invested is $23,000,000 | |||
Debt 55% $23,000,000 x 55% = $12,650,000 | |||
Equity 45% $23,000,000 x 45% = $10,350,000 | |||
rate of interest on debt is 13% | |||
A | EBIT | $4,600,000 | |
B | Less: Interest | $1,644,500 | |
[13% x $12,650,000] | |||
C = A-B | EBT | $2,955,500 | |
D | Less: Taxes @ 40% | $1,182,200 | |
[40% x $2,955,500] | |||
E =C-D | EAT | $1,773,300 | |
ROE for firm HL = EAT/Equity | |||
ROE for firm HL = $1,773,300 /$10,350,000 | |||
ROE for firm HL = 0.171333 | |||
ROE for firm HL = 17.13% | |||
C. | New ROE for LL is 16.50% | ||
Working Notes: | |||
New ROE for LL is 16.50% | |||
LL firm have 60% debt to capital ratio | |||
Total capital invested is $23,000,000 | |||
Debt 60% $23,000,000 x 60% = $13,800,000 | |||
Equity 40% $23,000,000 x40% = $9,200,000 | |||
rate of interest on debt is 15% | |||
A | EBIT | $4,600,000 | |
B | Less: Interest | $2,070,000 | |
[15% x $13,800,000] | |||
C = A-B | EBT | $2,530,000 | |
D | Less: Taxes @ 40% | $1,012,000 | |
[40% x $2,530,000] | |||
E =C-D | EAT | $1,518,000 | |
ROE for firm LL = EAT/Equity | |||
ROE for firm LL = $1,518,000 /$9,200,000 | |||
ROE for firm LL = 0.1650 | |||
ROE for firm LL = 16.50% | |||
Please feel free to ask if anything about above solution in comment section of the question. |