Question

3- Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $18 million in invested capital, has $2.7 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 12% interest on its debt, whereas LL has a 30% debt-to-capital ratio and pays only 9% interest on its debt. Neither firm uses preferred stock in its capital structure.

A/ 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 %

B/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 %

C\ Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 30% 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 is independent of the capital structure employed by the firms so ROIC = EBIT(1-T)/Invested capital

2.7*(1-0.40)/18 = 9%

For B.)

HL:

Net income = (EBIT - Interest on debt) x (1 - tax rate)

= [$2.7 mn - ($18 mn x 55% x 12%)] x (1 - 0.4)

= ($2.7 mn - $1.18 mn) x 0.60

= $0.912 mn

Similarly for LL,

NOPAT = (EBIT - Interest on debt) x (1 - tax rate)

= [$2.7 mn - ($18 mn x 30% x 9%)] x (1 - 0.4)

= ($2.7 mn - $0.486mn) x 0.60

= $1.3284 mn

ROE = Net income/Share holders equity

HL:

Net income (calculated as above) = $0.912 mn

Shareholder equity = 45% of total capital

= 45% x $18 mn = $8.1 mn

Therefore, ROE = $0.912 mn / $8.1 mn = 11.25%

For LL,

Net income (calculated as above) = $1.3284 mn

Shareholder equity = 70% of total capital

= 70% x $18 mn = $12.6 mn

Therefore, ROE = $1.3284 mn / $12.6 mn = 10.54%

C.)

LL raises Debt/capital ratio at 60% and interest will be 15%

Net income = (EBIT - Interest on debt) x (1 - tax rate)

= [$2.7 mn - ($18 mn x 60% x 15%)] x (1 - 0.4)

=$0.648 mn

Shareholder equity = 40% of total capital

= 40% x $18 mn = $7.2mn

ROE = 0.648/7.2 = 9%

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ROE = when NOPAT Shareholder's Equity