Financial leverage effects Firms HL and LL are identical except for their levera

Question

Financial leverage effects

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   %

FIND THE ROIC!!!

Explanation / Answer

Solution - We have here similar Invested Capital and Similar EBIT ( Earning Before Interest & Taxes ) difference is in Capital Structuring where the Debt to Equity Ratio is Different. So we need to first find out what is the Debt Portion ( Loans ) on which the Interest is Paid. As the Rate of interest is different too we need to find exact what amount of Interest each firm is paying. After we have the Interest Amount we need to reduce the Interest from EBIT to arrive at NPBT and then after reducing the Taxes we arrive at the Net Profit .

Below is the Solution to arrive at ROIC - Please refer Working Too

Working Note 0f F -

Debt to Equity ratio is calculated by debt divided by its total capital. Debt here is 45 % of the Capital . SO Rest will be equity -

Debt/Capital = Debt to Equity Ratio %

Debt / 16000000 = 45 % for HL & 20 % for LI

Debt = 45 % X16000000   for HL & 20 % X 16000000 for LI

Ans - ROIC for HL is 6.03% and for LL it is 7.92 %, this shows that a firm with greater Debt / Equity ratio pays more Interest expenses however reduces some amount on Taxation however Final Return on Investment is better with less Debt/equity Ratio.

Particular HL LL A Invested capital 16000000 16000000 B EBIT 2400000 2400000 C federal-plus-state tax rate 40% 40% D debt-to-capital ratio 45% 20% E interest on its debt 11% 9% F Debt - Refer Working Note( F ) 7200000 3200000 I Interest Yearly ( F X E) 792000 288000 NPBT Earning After Interest Before Taxes (B-I) AKA Net Profit Before Taxes 1608000 2112000 T Taxes (40% on NPBT ) C X NPBT 643200 844800 NPAT Earning After Interest & Taxes ( NPBT -T) AKA Net Profit After Tax 964800 1267200 ROIC Return on Invested Capital ( NPAT / Invested Capital ) 6.03% 7.92%

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