Question

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $14 million in invested capital, has $2.1 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 45% and pays 11% 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.

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 35% 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

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Answer:

LL's debt = 35%*14 = 4.9 million

LL's equity = 14-4.9 = 9.1 million

HL's debt = 45%*14 = 6.3 million

HL's equity = 14-6.3 = 7.7 million

Net income for LL = (EBIT-debt*10%)*(1-tax rate) = (2.1-4.9*10%)*(1-40%) = 0.966 million

Net income for HL = (EBIT-debt*11%)*(1-tax rate) = (2.1-6.3*11%)*(1-40%) = 0.8442 million

1. ROIC for LL = EBIT*(1-tax rate)/invested capital = 2.1*(1-40%)/14 = 9%

ROIC for HL = EBIT*(1-tax rate)/invested capital = 2.1*(1-40%)/14= 9%

3. ROE for LL = net income/equity = 0.966/9.1 = 10.62%

ROE for HL = net income/equity = 0.8442/7.7 = 10.96%

5. New equity for LL = 14*(1-60%) = 5.6 million

New debt for LL = 14*60% = 8.4 million

New net income for LL = (EBIT-debt*15%)*(1-tax rate) = (2.1-8.4*15%)*(1-40%) = 0.504 million

New ROE for LL = new net income/new equity = 0.504/5.6 = 9%