Question

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 $4.2 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 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.
Return on invested capital	Net income/Capital invested
Calculate proportion of debt and equity
	Firm LL	Weights firm LL		Firm HL	Weights firm HL
Debt	0.25	20.00%	0.25/1.25	0.60	37.50%	0.60/1.6
Equity	1.00	80.00%	1/1.25	1.00	62.50%	1/1.6
Total	1.25			1.60
Calculation of ROIC for both firm is shown below
	Firm LL	Firm HL
EBIT	$4,200,000	$4,200,000
Less: Interest expense	$378,000	$866,250
	(21million*20%*9%)	(21million*37.5%*11%)
Earnings before tax	$3,822,000	$3,333,750
Taxes @ 40%	$1,528,800	$1,333,500
Net income	$2,293,200	$2,000,250
Capital invested	$21,000,000	$21,000,000
ROIC	10.92%	9.53%
b.
ROE	Net income/Value of equity
	Firm LL	Firm HL
Net income	$2,293,200	$2,000,250
Value of equity	$16,800,000	$13,125,000
	21000000*80%	21000000*62.5%
Return on equity	13.65%	15.24%
c.
	Firm LL
EBIT	$4,200,000
Less: Interest expense	$1,181,250
	(21million*37.5%*15%)
Earnings before tax	$3,018,750
Taxes @ 40%	$1,207,500
Net income	$1,811,250
Value of equity	$13,125,000
	21000000*62.5%
Return on equity	13.80%