ROIC for firm LL is _____________% ROIC for firm HL is _____________% Firms HL a
ID: 2672897 • Letter: R
Question
ROIC for firm LL is _____________%ROIC for firm HL is _____________%
Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $28 million in invested capital, has $5.6 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 11% interest on its debt, whereas LL has a 30% debt-to-capital ratio and pays only 9% interest on its debt. Neither firm uses preferred stock in its capital structure.
1. 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
LL: D/TA = 30%.
EBIT $4,000,000
Interest ($6,000,000 ´ 0.10) 600,000
EBT $3,400,000
Tax (40%) 1,360,000
Net income $2,040,000
Return on equity = $2,040,000/$14,000,000 = 14.6%.
HL: D/TA = 50%.
EBIT $4,000,000
Interest ($10,000,000 ´ 0.12) 1,200,000
EBT $2,800,000
Tax (40%) 1,120,000
Net income $1,680,000
Return on equity = $1,680,000/$10,000,000 = 16.8%.
B. Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt ratio from 30% to 60% even though that would increase LL's interest rate on all debt to 15% . Calcuate the new ROE for LL.
LL: D/TA = 60%.
EBIT $4,000,000
Interest ($12,000,000 ´ 0.15) 1,800,000
EBT $2,200,000
Tax (40%) 880,000
Net income $1,320,000
Return on equity = $1,320,000/$8,000,000 = 16.5%.
Although LL’s return on equity is higher than it was at the 30% leverage ratio, it is lower than the 16.8% return of HL.
Initially, as leverage is increased, the return on equity also increases. But, the interest rate rises when leverage is increased. Therefore, the return on equity will reach a maximum and then decline.
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