Question

14-4   a.   For Company LL (Low Leverage), the total assets is $20,000,000, Debt ratio is 30%, the interest rate is 10%, tax rate is 40%, and EBIT is $4,000,000. What’s LL’s return on equity (ROE)? ROE = Net Income / Equity
20,000,000x30%=600,000
       Fro Company HL (High Leverage), the total assets is $20,000,000, Debt ratio is 50%, the interest rate is 12%, tax rate is 40%, and EBIT is $4,000,000. What’s HL’s return on equity (ROE)?

b.   IF Company LL’s debt ratio is increased to 60% with interest rate of 15%, and other things remain unchanged as above, What’s LL’s ROE? Will it be higher than HL’s ROE? If not, why?

Answer 1

a. LLL

EBIT=4000000

Less Interest= Rate*Debt ratio*Total assets

=10%*30%*20000000

= 600000

Profit before tax = 3400000

Less Tax = 40% = 1360000

Net Income= 2040000

Equity= (70%*20000000)

= 14000000

ROE= 2040000/14000000

= 0.1457142857

=14.57%

HLL

EBIT=4000000

Less Interest= Rate*Debt ratio*Total assets

=12%*50%*20000000

=1200000

Profit before tax = 2800000

Less Tax = 40% = 1120000

Net Income= 1680000

Equity= (50%*20000000)

= 10000000

ROE= 1680000/10000000

=16.8%

B.

LLL

EBIT=4000000

Less Interest= Rate*Debt ratio*Total assets

=15%*60%*20000000

=1800000

Profit before tax = 2200000

Less Tax = 40% = 880000

Net Income= 1320000

Equity= (40%*20000000)

= 8000000

ROE= 1320000/8000000

=16.5%

It is not higher than HLL's ROE. Due to greater debt the interest rate has increased a lot which has increased the cost of debt even after tax benefit. Hence the interest payments are much higher and this has reduced the net income.