Firms HL and LL are identical except for their leverage ratios and the interest
ID: 2792488 • Letter: F
Question
Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $25 million in invested capital, has $5 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 11% interest on its debt, whereas LL has a 25% 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. 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 25% 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
Answer:
ROIC formula: EBIT(1-tax rate)/Invested capital
HL ROIC value = 5(1-0.4)/25 = 3/25 = 0.12 or 12%
Similarly LL ROIC will also be 12% as values are the same for both
ROE Formula = Net income/ Shareholders equity
Shareholders equity = invested capital - debt capital
First we will have to calculate net income for both of them
LL: Debt to capital : 25%
Debt Capital =25% * 25 = 6.25 million
EBIT = 5 million
Interest = 6.25 * 10% = 0.625 million
PBT = 5 - 0.625 = $4.375 million
Tax (40% ) = 4.375 * 0.4 = $1.75 million
PAT ( Net income) = $2.625 million
ROE = 2.625/(25- 6.25) = 0.14 or 14%
Similarly For HL:
Debt to capital 60%
Debt capital : 25 * 0.6 = 15 million
EBIT = 5 million
interest : 15 * 0.11 = $1.65 million
PBT = 5- 1.65 = 3.35 million
Tax (40%) = 3.35 * 0.4 = $1.34 million
PAT = $ 2.01 million
ROE = 2.01 /(25- 15) = 0.201 or 20.10%
New ROE for LL
Debt capital will be 15 million
EBIT = 5 million
Interest : 15* 0.15 = $2.25 million
PBT = $2.75 million
Tax(40%) = 2.75 * 0.4 = 1.1 million
PAT = $1.65 million
ROE = 1.65 / ( 25-15 ) = 0.165 or 16.50%
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