Financial leverage effects Firms HL and LL are identical except for their levera

Question

Financial leverage effects

Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $16 million in invested capital, has $2.4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 45% and pays 11% interest on its debt, whereas LL has a 20% 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   %

Explanation / Answer

The term Leverage has come from science term 'Lever'. It is a mechanical devise used to lift maximum weight with minmum force. Suppose a piece of rod AB is fixed at middle point C by a mechanical devise known as 'fulcrum'. Now you put pressure on end A. It will help you to lift weight attached at end B. The fulcrum will help you to put minimum force to lift the weight. Thus fixed point C is known as lever.

In finance leverage indicates a financial relation between return on invested capital and earning. Here invested capital will mean investment in equity share. Basic objective of every firm is to maximize the value of of ROIC> It will help the firm to maximize its value in the form of increase in market price of stock. Existence of some fixed element of costs will help the firm to achieve it.

Fixed elements of cost are of two type. They are:

1. Fixed cost of production. These element of cost does not change with the change in output. Contractual payments like factory rent are fixed in nature. It is known as operating leverage.

2. Perhaps most crucial leverage is found in the financial structure of the company. A portion of the total fund invested is debt capital and balance is equity capital. Debt capital owners are paid interest for using their fund. It is fixed in nature. Low cost debt capital ultimately helps the company to imcrease or maximze the return on equity fund. It is known as financial leverage.

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In this probl;em two firms have same amount of EBIT and total fund employed. But the comosition of funding is different. Firm HL is using more debt capital than firm LL. HL has 45% debt-equity ratio while LL has a ratio of 20% only. Interest rate on debt capital are 11% and 9% respectively. Both are paying same percentage (40%) of tax. On the basis of above information calculation of ROIC is shown below:

Note: 1. HL company has used debt captal ratio of 45%. Total invested capital is 16 million. 45% of it is debt capital and balance is equity capital. Foir LL it is 20% only.

2. ROIC will mean return on invested capital of 16 million. Here return will include interest and EAT. Interest is the return on debt capital and EAT is the return on equity capital.

Result: Note that ROIC of HL is higher than ROIC of LL. It is due to high financial leverage of HL. Interest is eligible deduction under income tax act. It has helped HL to pay less tax. Hence EAT is high. The effect of financial leverage is better assessed if the ratio of EAT to equity fund is calculated. It will be 0.9648/8.8=10.96% for HL and 1.2672/12

HL LL 1. Invested capital consisting of : Debt [HL: $16million X45/100] [LL: $16 million X 20/100] $7.2 $3.2 Equity {HL:16-4.9655] [LL: 16-2.667] $8.8 $12.8 2. EBIT $2.4 $2.4 3. Interest [HL: 7.2x11%] [LL: 3.2 X 9%] $0.792 $0.288 4. EBT { 2 - 3] $1.608 $2.112 5. Tax @ 40% on EBT $.0.6432 $0.8448 6. Earniongs after tax (EAT) [4 - 5] $0.9648 $1.2672 7. ROIC [(EAT+interest)*100/Invested capital] [(6+3)*100/16million] 10.98% 9.72%

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