Firms HL and LL are identical except for their leverage ratios and the interest
ID: 2659464 • Letter: F
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 $2.6 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 50% and pays 12% interest on its debt, whereas LL has a 25% 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 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.
%
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Explanation / Answer
HL LL EBIT $2,600,000 $2,600,000 Assets $13,000,000 $13,000,000 Debt $6,500,000 $3,900,000 Equity $6,500,000 $9,100,000 Interest Rate 12% 8% Tax rate 50% 25% a) HL LL EBIT $2,600,000 $2,600,000 Interest $780,000 $312,000 EBT $1,820,000 $2,288,000 Tax (40%) $728,000 $915,200 Net Income $1,092,000 $1,372,800 ROE 16.80% 15.09% b) LL EBIT $3,000,000 Assets $20,000,000 Debt $12,000,000 Equity $8,000,000 Interest Rate 15% Tax rate 40% EBIT $3,000,000 Interest $1,800,000 EBT $1,200,000 Tax (40%) $480,000 Net Income $720,000 ROE 9.00%
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