Question

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $13 million in invested capital, has $1.95 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 45% and pays 11% interest on its debt, whereas LL has a 25% debt-to-capital ratio and pays only 8% interest on its debt. Neither firm uses preferred stock in its capital structure. 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   % 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    % 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) For LL,

Total debt = 25% * Invested capital

Total debt = 25% * 13

Total debt = $3.25 million

Interest on debt = 8% * 3.25

Interest on debt = 0.26 million

Similarly, for HL

Total debt = 45% * Invested capital

Total debt = 45% * 13

Total debt = $5.85 million

Interest on debt = 11% * 5.85

Interest on debt = 0.6435 million

Refer to the table for Net Income calculation

EBIT - Interest = EBT

EBT - 40% * EBT = Net Income

ROIC = Net Income / invested capital

	LL	HL
EBIT	1.95	1.95
Interest	0.26	0.6435
EBT	1.69	1.3065
Tax	0.676	0.5226
Net Income	1.014	0.7839
ROIC	7.80%	6.03%

ROIC for firm LL is 7.80%

ROIC for firm HL is 6.03%

b) ROE calculation

For LL firm

Equity = Invested capital - debt

Equity = 13 - 3.25

Equity = 9.75 million

ROE = Net Income / Equity

ROE = 1.014 / 9.75

ROE = 10.40%

For HL firm

Equity = Invested capital - debt

Equity = 13 - 5.85

Equity = 7.15 million

ROE = Net Income / Equity

ROE = 0.7839 / 7.15

ROE = 10.96%

ROE for firm LL is 10.40%

ROE for firm HL is 10.96%

c) Now, Debt to capital ratio for LL is 60%

Total debt = 60% * Invested capital

Total debt = 60% * 13

Total debt = $7.8 million

Interest on debt = 15% * 7.8

Interest on debt = 1.17 million

EBIT    = 1.9 million

Less Interest = 1.17

EBT             = 0.78

Tax @ 40% = 0.312

Net Income = 0.468

Equity = Total invested capital - Debt

Equity = 13 - 7.8

Equity = 5.2 million

ROE = Net Income / Equity

ROE = 0.468 / 5.2

new ROE for LL = 9.00%

Even though the debt has increased, ROE has decreases. This is because the interest rate on the debt has become too high which has led to decrease in the firm's Net Income drastically. Thus, leading to lower ROE for the firm. Hence a right combination of debt with interest rate is essential to improve ROE of the firm