Observing that HL has a higher ROE, LL\'s treasurer is thinking of raising the d
ID: 2672900 • Letter: O
Question
Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 30% to 60%, even though that would increase LL's interest rate on all debt to 15%. Calculate the new ROE for LL. 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._______________%
Explanation / Answer
Breakeven Analysis: A company's fixed operating costs are $500,000, its variable costs are $3.00 per unit, and the product's sales price is $4.00. What is the company's breakeven point; that is, at what unit sales volume will its income equal its costs? BEP = Fixed Costs / Unit Contribution Margin = $500,000 / ($4-$3) = 500,000 units Financial Leverage effects. Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $20 million in assests, has $4 million of EBIT, and is in the 40% federal-plus-state-tax bracket. Firm HL, however, has a debt ratio and pays only 10% interest on its debt. A. Calculate the rate of return on equity(ROE) for each firm. 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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