Question

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $28 million in invested capital, has $5.6 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 50% 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.

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 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.

Answer 1

Please see the table below. All financials are in $ mn.

Please see the column titled "Linkage". That will help you understand how each row has been calculated. Final answers are highlighted in yellow colored cells.

Parameter	Linkage	HL	LL
Invested Capital	A	28	28
Debt to Capital Ratio	B	50%	20%
Debt portion	C = A x B	14	5.6
Equity portion	D = A - C	14	22.4
Interest rate on debt	E	11%	8%
Tax rate	F	40%	40%
EBIT	G	5.60	5.60
NOPAT	H = G x (1 - F)	3.36	3.36
ROIC	H / A	12.00%	12.00%
Interest expenses	I = C x E	1.54	0.45
EBT	J = G - I	4.06	5.15
Taxes	K = J x F	1.62	2.06
Net Income	L = J - K	2.44	3.09
ROE	L / D	17.40%	13.80%

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%.

ROE calculation is shown below. Final answer is in the last row highlighted in yellow colored cell.

Parameter	Linkage	LL
Invested Capital	A	28
Debt to Capital Ratio	B	60%
Debt portion	C = A x B	16.8
Equity portion	D = A - C	11.2
Interest rate on debt	E	15%
Tax rate	F	40%
EBIT	G	5.60
Interest expenses	I = C x E	2.52
EBT	J = G - I	3.08
Taxes	K = J x F	1.23
Net Income	L = J - K	1.85
ROE	L / D	16.50%