Question

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $21 million in invested capital, has $4.2 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 25% debt-to-capital ratio and pays only 9% 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 25% 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 result using the provided information as below

ROIC is the return that the company earns on the capital invested. So the formula to calculate ROIC is

= [EBIT ( 1-Tax rate ) / Capital Invested] * 100

Both the firms LL & HL have similar EBIT, Capital invested and the Tax rate which are

EBIT = $ 4.2 million ; Capital invested = $ 21 million and tax rate = 40%

ROIC = [4.2 ( 1 - 40% ) / 21] *100

= ( 2.52 / 21 ) * 100 = 12.00%

So, the ROIC of both LL & HL limited will be 12.00%

Rate of return on Equity : It is the return that company generates from the amount of money invested by the equity shareholders. WE can calculate the ROE for both companies as follows

Details	Company HL	Company LL
EBIT	$ 4.2 Million	$ 4.2 Million
Interest paid (Capital invested * debt percent * interest rate)	$ 1.386 million ( 21 * 60% * 11%)	$ 0.473 million ( 21 * 25% * 9%)
EBT (EBIT - Interest paid)	$ 2.814 million	$ 3.727 million
Tax [ EBT * ( 1 - tax rate) ]	$ 1.126 million	$ 1.491 million
Net Income ( EBT - Tax)	$ 1.688 million	$ 2.236 million
Total Equity ( 1- Debt ratio) * Invested capital	(1 - 60%) * 21 = $ 8.4 million	(1 - 25%) * 21 = $ 15.75 million

Now as we have Net Income and equity of both firms

ROE of HL = Net Income / total equity

= 1.688 / 8.40

= 0.201 or 20.10%

ROE of LL = Net Income / total equity

= 2.236 / 15.75

= 0.1419 or 14.19%

ROE of LL with new capital structure

New Debt ratio = 60% & new interest rate = 15%

Details	Company LL
EBIT	$ 4.2 Million
Interest paid (Capital invested * debt percent * interest rate)	$ 1.89 million ( 21 * 60% * 15%)
EBT (EBIT - Interest paid)	$ 2.31 million
Tax [ EBT * ( 1 - tax rate) ]	$ 0.924 million
Net Income ( EBT - Tax)	$ 1.386 million
Total Equity ( 1- Debt ratio) * Invested capital	(1 - 60%) * 21 = $ 8.4 million

New ROE of LL = Net Income / total equity

= 1.386 / 8.40

= 0.165 or 16.50%

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