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 $19 million in invested capital, has $4.75 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 10% interest on its debt. Neither firm uses preferred stock in its capital structure.

A. 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 _____%

B. 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 _____%

C. 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.

_____%

Explanation / Answer

(A) ROIC = Net Income / Invested Capital

HL:

Net income = (EBIT - Interest on debt) x (1 - tax rate)

= [$4.75 mill - ($19 mill x 60% x 12%)] x (1 - 0.4)

= ($4.75 mill - $1.37 mill) x 0.60

= $2.03 mill

So, ROIC = $2.03 mill / $19 mill

= 10.67%

LL

Net income = (EBIT - Interest on debt) x (1 - tax rate)

= [$4.75 mill - ($19 mill x 40% x 10%)] x (1 - 0.4)

= ($4.75 mill - $0.76 mill) x 0.60

= $2.39 mill

So, ROIC = $2.03 mill / $19 mill

= 10.67%

(B) ROE = Net Income / Shareholder Equity

HL:

Net income (calculated as above) = $2.03 mill

Shareholder equity = 40% of total capital

= 40% x $19 mill = $7.6 mill

So, ROE = $2.03 mill / $7.6 mill = 26.71%

LL

Net income (calculated as above) = $2.39 mill

Shareholder equity = 60% of total capital

= 60% x $19 mill = $11.4 mill

So, ROE = $2.39 mill / $11.4 mill = 20.96%

(C) LL raises debt to 60% at 15% rate.

So, interest payment = $19 mill x 60% x 15% = $1.71 mill

Net income = (EBIT - interest) x (1 - tax rate)

= $(4.75 - 1.71) mill x 0.6

= $1.82 mill

New ROE = $1.82 mill / $11.4 mill

= 16%

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