Question

FINANCIAL LEVERAGE EFFECTS

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $26 million in invested capital, has $5.2 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 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

A. ROIC = EBIT * (1 – Tax Rate) / Total Invested Capital. EBIT * (1 – Tax Rate) is also called as NOPAT (Net Operating Profit less Adjusted Taxes). Since EBIT, tax and invested capital figures are identical for HL and LL, their ROIC will also be same. NOPAT = $5.2mn * (1 – 40%) = $3.12mn. Hence ROIC for both firms = $3.12mn / $26mn = 12.00%

B. Return on equity (RoE) = Net income / Equity. For calculation of RoE, we need to ascertain net income and equity for both firms. Debt-to-Capital ratio for HL and LL is 55% and 25% respectively. Hence Debt for HL and LL is $26mn * 55% i.e. $14.30mn and $26mn * 25% i.e. $6.50mn respectively. Hence annual interest payments for HL and LL is $14.30% * 13% i.e. $1.86mn and $6.50mn * 9% i.e. $0.59mn respectively. Net income = (EBIT – Interest) * (1 – Tax). Hence Net income for HL is ($5.20mn - 1.86mn) * (1 – 40%) = $2.00mn. Similarly, net income for LL is ($5.20mn - $0.59mn) * (1 – 40%) = $2.77mn. Equity for HL and LL is $26mn - $14.30mn i.e. $11.70mn and $26mn - $6.50mn i.e. $19.50mn. Hence, RoE for HL = $2.00mn / $11.70mn = 17.13%. Similarly, RoE of LL = $2.77mn / $19.50mn = 14.20%

C. If Debt-to-Capital ratio of LL is increased from 25% to 60% with interest rate to 15%, net income of LL will decline to ($5.20mn – ($26mn * 60% * 15%)) * (1 – 40%) = $1.72mn. Equity component would be $26mn * (1 – 60%) = $10.40mn. Hence, revised RoE = $1.72mn / $10.40 mn = 16.50%             

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