Firms HL and LL are identical except for their leverage ratios and the interest

Question

Firms HL and LL are identical except for their 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 30% debt-to-capital ratio and pays only 9% interest on its debt. Neither firm uses preferred stock in its capital structure.

1. 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 _____________%

2. 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 _______________%

3. 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. Round your answer to two decimal places.

_______________%

Explanation / Answer

a)Firm HL Earnings = ($5.6-50%*$28*11% ).6=2.436 million ROIC for firm HL is =2.436/28=8.70% Firm LL Earnings =($5.6-30%*$28*9% ).6=$2.9064 million ROIC for firm LL is =$2.9064/28=10.38% ROIC for firm LL is 10.38% ROIC for firm HL is 8.70% b. ROE for firm LL =$2.9064/(70%*$28)=14.83% ROE for firm HL =2.436 /(50%*28)=17.40% c.New Earnings of LL=($5.6-60%*$28*15% ).6=$1.848 million ROE for firm LL =$1.848/(30%*$28)=22.00%

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