In: Finance
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 $6.3 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 35% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure.
LL's debt = 35% x $21 million = $7.35 million
LL's equity = $21 million - $7.35 = $13.65 million
HL's debt = 60% x $21 million = $12.60 million
HL's equity = $21 million - $12.60 million = $8.40 million
Net income for LL = (EBIT-Debt x 10%) x (1-Tax rate)
= (6.3-7.35*10%)*(1-40%)
= $3.339 million
Net income for HL = (EBIT-Debt*11%)*(1-Tax rate)
= (6.3-12.6*11%)*(1-40%)
= $2.9484 million
a.
ROIC for LL = EBIT*(1-Tax rate)/Invested capital
= 6.3*(1-40%)/21
= 18.00%
ROIC for HL = EBIT*(1-Tax rate)/Invested capital
= 6.3*(1-40%)/21
= 18.00%
c.
ROE for LL = Net income/Equity
= $3.339 million / $13.65 million
= 24.46%
ROE for HL = Net income/Equity
= $2.9484 million / $8.40 million
= 35.10%
e.
New equity for LL = $21 x (1-60%) = $8.40 million
New debt for LL = $21 x 60% = $12.60 million
New net income for LL = (EBIT-Debt x 15%) x (1-Tax rate)
= (6.3-12.6*15%)*(1-40%)
= $2.646 million
New ROE for LL = New net income/New equity = $2.646 million /
$8.40 million
= 31.5%