Leverage Effects Analysis Firms HL and LL are identical except for their financi

Question

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. 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 wouid increase LL's interest rate on all debt to 15%. Calculate the new ROE for LL.

Explanation / Answer

Solution:

Invested capital for both firms (C) = $20MM, EBIT for both firms = $4MM, Tax rate = 40%,

1. Return on invested capital (ROIC) = (Net income/Capital invested )*100

For HL, calculation of net income

               EBIT = $4.00MM, Interest rate = 12%
Hence, interest on EBIT = 12% * 4 = $0.48MM
                     PBT = EBIT - Interest on EBIT = 4 - 0.48 = $3.52MM
               tax = tax rate * PBT = 40% * 3.52 = $1.41MM
Hence, Net income = PBT - tax = 3.52-1.41 = $2.11MM

Return on invested capital = Net income/Capital *100 = (2.11/20)*100 = 10.6%
Hence, ROIC for HL = 10.6%

For LL, calculation of net income

                         EBIT = $4.00MM, Interest rate = 10%
Hence interest on EBIT = 10% * 4 = $0.4MM
                PBT = EBIT - interest = 4 - 0.4 = $3.60MM
              tax = 40% * 3.60 = $1.44MM
   Net income = PBT - tax = 3.60-1.44 = $2.16MM

Hence, ROIC for LL = Net income/C * 100 = (2.16/20) * 100 = 10.8%

ROIC for LL = 10.8%

2. Return on Equity = (Net income/Equity)*100

For HL, Calculation of equity,

Debt/Capital = 50% (1)
  Now capital = debt + equity and capital is given to be $20.0MM,
Hence, 20 = debt + equity
So replace capital by 20 and debt by (20 - equity) in (1), we get

(20-equity)/20 = 50%, calculating for equity = $10.0MM

Now net income for HL (as calculated in previous part) = $2.11MM

   Hence, ROE = (2.11/10)*100 = 21.1%

Hence, ROE for HL = 21.1%

For LL, calculation of Equity

Debt/Capital = 30%, (so as done for HL above)
(20-Equity)/20 = 30%, calculating for equity = $14.0MM

Now, net income for LL = $2.16MM, Equity = $14.0MM
ROE = (2.16/14) * 100 = 15.4%,

Hence ROE for LL = 15.4%

3. Now, Debt to capital for LL = 60% and Interest rate is 15%, so both equity and net income will change for LL,

Calculation of net income
    EBIT = $4.0MM
Interest on EBIT = 15% * 4 = 0.6MM
PBT = EBIT - Interest = 4 - 0.6 = $3.4MM
Tax = 40% * 3.4 = $1.36MM
             Hence, net income = PBT - tax = 3.40 - 1.36 = $2.04MM

Hence, changed net income for LL = $2.04MM

Calculation for equity

Debt/Capital = 60%, hence
(20-Equity)/20 = 60%,

Hence, equity = $8.00MM

Now ROE = (Net income/Equity) *100
         ROE = (2.04/8) * 100
                 = 25.5%

hence, new ROE for LL = 25.5%

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