ROIC breakdown, a firms HL and LL are identical except for their leverage ratios
ID: 2672901 • Letter: R
Question
ROIC breakdown, a 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 return on invested capital (ROIC) for each firm.
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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