Firms HL and LL are identical except for their leverage ratios and the interest
ID: 2644594 • Letter: F
Question
Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $16 million in invested capital, has $2.4 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 20% debt-to-capital ratio and pays only 9% 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 %
Explanation / Answer
Formula for Return on Invested Capital ( ROIC) : Earnings Available for Equity Shareholders/ Equity Shareholders' Fund
or
Net Operating Profit After Tax ( NOPAT) /Equity Shareholders' Fund
1. Calculation of Earnings Available for Equity Shareholders for Firm HL and Firm LL
Firm HL Firm LL
EBIT ( given)= 24,00,000 EBIT = $24,00,000
Less : Interest ( Calculation below)= 7,92,000 Less: Interest = 2,88,000
EBT( Earnings before tax) =16,08,000 EBT = 21,12,000
Tax ( 40%) = 6,43,200 Tax(40%) = 8,44,800
(16,08,000*40%) (21,12,000*40%)
EAT(Earnings after tax)= 9,64,800 EAT= 12,67,200
2. Calculation of Interest:
Debt to capital ratio ( given) = 45% Debt to capital ratio = 20%
Debt= not given Debt= not given
Capital= 160,00,000 Capital= 160,00,000
Debt/Capital= 45% Debt/Capital=20%
Debt/160,00,000=45% Debt/160,00,000=20%
Debt = 160,00,000*45% Debt= 160,00,000*20%
Debt= 72,00,000 Debt= 32,00,000
Interest = 11% on debt Interest= 9 % on Debt
Interest= 72,00,000 *11% Interest= 32,00,000 * 9%
Interest= 7,92,000 Interest= 2,88,000
3. Calculation of Return on Invested Capital( ROIC)= Net Operating Profit After Tax / Equity Shareholders' Fund
Firm HL Firm LL
NOPAT= 9,64,800 NOPAT= 12,67,200
Equity Shareholders Fund= Equity share capital + Reserves- P&L( Debit balance)
Equity Shareholders Fund = 160,00,000 Equity Shareholders Fund = 160,00,000
ROIC= ,964,800/160,00,000 *100 ROIC= 12,67,200/160,00,000 *100
ROIC= 6.03% ROIC = 7.92%
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