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 $13 million in invested capital, has $3.9 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 60% and pays 12% interest on its debt, whereas LL has a 30% debt-to-capital ratio and pays only 8% 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   %

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    %

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

For Firm HL For firm HL the total invested capital is $13 million and the profit EBIT is $3.9 million The firm is in 40% tax bracket Also the debt to capital ratio is 60% and it pays 12% interest on its debt. Hence by using this information we can fing out the NOPAT for the firm. NOPAT is Net Operating Profit After Tax Now by using the information above we can get for the firm HL: Debt (60%) $7.80 mn Equity (40%) $5.20 mn EBIT $ 3,900,000.00 Tax $ 1,560,000.00 NOPAT $ 2,340,000.00 Interest(12%) $936,000.00 Earning to Shareholders $1,404,000.00 Now we know that Return on Invested Capital = NOPAT/Total Capital = $2340000/$13000000=   18.00% Also Return on equity = Earnings to shareholders/Total equity = $1404000/$5200000 = 27.00% For Firm LL For firm LL the total invested capital is $13 million and the profit EBIT is $3.9 million The firm is in 40% tax bracket Also the debt to capital ratio is 30% and it pays 8% interest on its debt. Hence by using this information we can find out the NOPAT for the firm. NOPAT is Net Operating Profit After Tax Now by using the information above we can get for the firm HL: Debt (30%) $3.90 mn Equity (70%) $9.10 mn EBIT $      3,900,000.00 Tax $      1,560,000.00 NOPAT $      2,340,000.00 Interest(8%) $312,000.00 Earning to Shareholders $2,028,000.00 Now we know that Return on Invested Capital = NOPAT/Total Capital = $2340000/$13000000=   18.00% Also Return on equity = Earnings to shareholders/Total equity = $2028000/$9100000 = 22.29% If debt to capital ration changes from 30% to 60 percent then in that case the following calculation would take place: Interest on debt also increases from 8% to 15%. Debt (60%) $7.80 mn Equity (30%) $5.20 mn

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