FINANCIAL LEVERAGE EFFECTS Analysis Firms HL and LL are identical except for the

Question

FINANCIAL LEVERAGE EFFECTS Analysis Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $20 million in invested capital, has $4 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 12% interest on its debt, whereas U. has a 30% debt-to-capital ratio and pays only 10% interest on its debt. Neither Firm uses preferred stock in its capital structure. Please show all calculations.

a) Calculate the return on invested capital (ROIC) for each firm.

b) Calculate the return on equity (ROE) for each firm.

c) Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 30% to 60% even though that would increase LL's interest rate on all debt to 15%. Calculate the new ROE for LL.

Explanation / Answer

S NO Particulars Firm HL(In $) Firm LL(In $) A Total Capital Invested 20 20 B Equity Portion 10(20*50%) 14(20*70%) C Debt Portion 10 6 Return on Invested Capital and Equity A EBIT 4 4 B Less:Interest 1.2(12% of 10) 0.6(10% of 6) C EBT 2.8 3.4 D Less:Tax@40% 1.12 1.36 E Earing after Tax 1.68 2.04 F Add:Interest 1.2 0.6 G Earning after tax but before Interest 2.88 2.64 H Return on Invested Capital 14.4%(2.88/20*100) 13.2%(2.64/20*100) I Return on Equity 16.8%(1.68/10*100) 14.57%(2.04/14*100) C)The new ROE for LL if Capital ratio changes from 30 to 60% S No Particulars LL A Total Invested Capital 20 B Debt ratio 12 C Equity ratio 8 Return on Equity A EBIT 4 B Less:Interest(15% of 12) 1.8 C EBT 2.2 D Less:Tax@40% 0.88 E EAT 1.32 F New Return on Equity(1.32/8) 16.5%

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