Firms HL and LL are identical except for their leverage rati

Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $30 million in invested capital, has $4.5 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 12% interest on its debt, whereas LL has a 40% debt-to-capital ratio and pays only 9% 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 40% 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.

________ %

Solution

Answer a.

Firm LL:

Invested Capital = $30,000,000
EBIT = $4,500,000
Tax Rate = 40%

ROIC = EBIT * (1 - tax)/ Invested Capital
ROIC = $4,500,000 * (1 - 0.40) / $30,000,000
ROIC = 9%

Firm HL:

Invested Capital = $30,000,000
EBIT = $4,500,000
Tax Rate = 40%

ROIC = EBIT * (1 - tax)/ Invested Capital
ROIC = $4,500,000 * (1 - 0.40) / $30,000,000
ROIC = 9%

Answer b.

Firm LL:

Invested Capital = $30,000,000

Debt = 40% * $30,000,000
Debt = $12,000,000

Interest Expense = 9% * $12,000,000
Interest Expense = $1,080,000

Equity = 60% * $30,000,000
Equity = $18,000,000

Net Income = (EBIT - Interest Expense) * (1 - tax)
Net Income = ($4,500,000 - $1,080,000) * (1 - 0.40)
Net Income = $2,052,000

ROE = Net Income / Equity
ROE = $2,052,000 / $18,000,000
ROE = 11.4%

Firm HL:

Invested Capital = $30,000,000

Debt = 60% * $30,000,000
Debt = $18,000,000

Interest Expense = 12% * $18,000,000
Interest Expense = $2,160,000

Equity = 40% * $30,000,000
Equity = $12,000,000

Net Income = (EBIT - Interest Expense) * (1 - tax)
Net Income = ($4,500,000 - $2,160,000) * (1 - 0.40)
Net Income = $1,404,000

ROE = Net Income / Equity
ROE = $1,404,000 / $12,000,000
ROE = 11.7%

Answer c.

Firm LL:

Invested Capital = $30,000,000

Debt = 60% * $30,000,000
Debt = $18,000,000

Interest Expense = 15% * $18,000,000
Interest Expense = $2,700,000

Equity = 40% * $30,000,000
Equity = $12,000,000

Net Income = (EBIT - Interest Expense) * (1 - tax)
Net Income = ($4,500,000 - $2,700,000) * (1 - 0.40)
Net Income = $1,080,000

ROE = Net Income / Equity
ROE = $1,080,000 / $12,000,000
ROE = 9.00%