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

Question

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 LL has a 30% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure. Calculate the return on invested capital (ROIC) for each firm. Calculate the return on equity (ROE) for each firm. 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

Answer:

Particulars HL LL Debt to capital ratio 50% 30% Invested Capital 20000000 20000000 Debt 10000000 6000000 Equity 10000000 14000000 Interest rate 12% 10% EBIT 4000000 4000000 Intrest 1200000 600000 EBT 2800000 3400000 Tax(40%) 1120000 1360000 Net income 1680000 2040000 Return on invested capital (net imcome/invested capital) 8.40% 10.20% Return on equity capital (net imcome/equity capital) 16.80% 14.57% If Debt to capital ratio of LL from 30% to 60% the revised ROE calculated 60% Invested Capital 20000000 Debt 12000000 Equity 8000000 Interest rate 15% EBIT 4000000 Intrest 1800000 EBT 2200000 Tax(40%) 880000 Net income 1320000 Return on equity capital (net imcome/equity capital) 16.50%

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