ROE Breakdown PLEASE. Firms HL and LL are identical except for their leverage ra
ID: 2672899 • Letter: R
Question
ROE Breakdown PLEASE. 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.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 _______________%
Explanation / Answer
ROE = Net Income / Total Equity TA = 28m First, calculate each firm's debt: HL = 0.5 * 28m = 14m LL = 0.3 * 28m = 8.4m Calculate Net income for each company: (EBIT - interest expense)(1-Tax) HL = (5.6m - (0.11*14m))(0.6) = 2.436m LL = (5.6m - (0.09*8.4m))(0.6)= 2.9064m Then, calculate the Total Equity of each firm. Assuming that their debt is all they have for their liability (no current liability), Total Asset = Total Liability (debt) + Total Equity HL = 28m - 14m = 14m LL = 28m - 8.4m = 19.6m So ROE= NI/EQ HL = 2.436m/14m = 0.174 = 17.4% LL = 2.9064m/19.6m = 0.1482857..= 14.8% As you can see, companies with financial leverage tend to have higher ROE, although that increases their risk. Hope that helps! :)
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