Firms HL and LL are identical except for their leverage ratios and the interest
ID: 2734615 • Letter: F
Question
Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $11 million in invested capital, has $3.3 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 60% and pays 12% interest on its debt, whereas LL has a 20% debt-to-capital ratio and pays only 10% 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 20% 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.
%
Explanation / Answer
ROIC of HL company = netincome-dvidend/capital
total capital = 11 millios
total debt = 11*60/100=6.6 millions
interest = 6.6*12%= 0.792 millions
net income = (3.3-0.792)(1-0.4)= 1.5048
roic = 1.5048/11
= 0.1368=13.68%
ROIC of LL company = netincome-dvidend/capital
total capital = 11 millios
total debt = 11*20/100=2.2 millions
interest = 2.2*10%= 0.22 millions
net income = (3.3-0.22)(1-0.4)= 1.848
roic = 1.848/11
= 0.168=16.8%
calculation of return of equity of HL company
total capital = 11 millios
total debt = 11*60/100=6.6 millions
interest = 6.6*12%= 0.792 millions
net income = (3.3-0.792)(1-0.4)= 1.5048
roic = 1.5048/4.4=34.2%
ROE of LL company = netincome-dvidend/capital
total capital = 11 millios
total debt = 11*20/100=2.2 millions
interest = 2.2*10%= 0.22 millions
net income = (3.3-0.22)(1-0.4)= 1.848
roic = 1.848/8.8=21%
ROE of LL company = netincome-dvidend/equity
total capital = 11 millios
total debt = 11*60/100=6.6millions
interest = 6.6*15%= 0.99 millions
net income = (3.3-0.99)(1-0.4)= 1.386
roe of LL = 1.386/4.4
= 0.315
=31.5%
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