Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $20 million in invested capital, has $3 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 55% and pays 13% interest on its debt, whereas LL has a 20% debt-to-capital ratio and pays only 8% interest on its debt. Neither firm uses preferred stock in its capital structure.
(a) ROIC= Net operating profit after tax/Invested capital
NOPAT= EBIT(1-Tax rate) = 3 million*0.60= 1.80 million
ROIC= (1.80/20) = 9%
It is same for both the companies as EBIT and invested capital of both the companies is same and tax rate is also the same.
(b) ROE= Return available for equity shareholders/Equity capital
Firm LL has 80% equity capital i.e. 16 million
Return for equity= (EBIT-interst)*(1-tax rate)
=(3-0.32)*0.6 =1.608
ROE= 1.608/16= 10.05%
Firm HL has 45% equity capital= 9 million
Return for equity= (EBIT-interst)*(1-tax rate)
=(3-0.1.43)*0.60= 0.942
ROE= 0.942/9= 10.47%
(c) New ROE of LL
Return for equity =(3-1.80)*0.6= 0.72
Equity capital- 40% of 20 million= 8 million
New ROE= 0.72/8= 9%
Firms HL and LL are identical except for their financial leverage ratios and the interest rates...
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