Question

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $12 million in invested capital, has $3.6 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 11% interest on its debt, whereas LL has a 20% debt-to-capital ratio and pays only 8% 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.

What is the ROIC for firm LL ____ %

What is the ROIC for firm HL _____ %

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 a____ %

Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 20% 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. is ______ %

Answer 1

a]

ROIC = Net Operating Profit after Taxes (NOPAT) / Invested Capital

NOPAT = EBIT * (1 - Tax Rate)

ROIC for LL = ($3.6 million * (1 - 40%)) / $12 million = 18%

ROIC for HL = ($3.6 million * (1 - 40%)) / $12 million = 18%

b]

ROE = net income / equity capital

net income = (EBIT - interest) * (1 - tax rate)

equity capital = invested capital - debt

Debt of LL = Invested capital * debt-to-capital ratio = $12 million * 20% = $2.4 million

Interest expense of LL = Debt * interest rate = $2.4 million * 8% = $192,000

ROE for LL = ($3.6 million - $192,000) * (1 - 40%) / ($12 million - $2.4 million)

ROE for LL = 21.3%

Debt of HL = Invested capital * debt-to-capital ratio = $12 million * 55% = $6.6 million

Interest expense of LL = Debt * interest rate = $6.6 million * 11% = $726,000

ROE for HL = ($3.6 million - $726,000) * (1 - 40%) / ($12 million - $6.6 million)

ROE for HL = 31.93%

New ROE for LL :

New debt of LL = $12 million * 60% = $7.2 million

New Interest expense of LL = $7.2 million * 15% = $1,080,000

New ROE for LL = ($3.6 million - $1,080,000) * (1 - 40%) / ($12 million - $7.2 million)

New ROE for LL = 31.5%