Question

FINANCIAL LEVERAGE EFFECTS 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. 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 b. 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 c. 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.

Answer 1

Part a.

For ROIC we use the following formula:

EBIT(1 - T)/Total invested capital ROIC

ROIC for LL:

=3000000*(1-40%)/20000000

=9.00%

Similarly for HL also the ROIC will be same:

=3000000*(1-40%)/20000000

=9.00%

Part b.

Net income Return on common equity (ROE) Common equity

For this we first need to find net income for both the cases by deducting Interest & Tax expenses from EBIT as shown below:

				HL	LL
Invested capital				20000000	20000000
EBIT				3000000	3000000
Tax bracket				40%	40%
Debt ratio				55%	20%
Interest expenses				13%	8%
Interest payment				14,30,000	3,20,000	=Interest rate* (Debt ratio * Invested capital)
Tax payment				628000	1072000	=Tax rate * (EBIT- Interest expense)
Net Profit after Tax				2372000	1928000	=EBIT- Tax payment
ROE				26.36%	12.05%	= Net Income/(Capital * (1- Debt ratio))

Part c.

With the proposed changes, the calculations for LL's ROE would get changed as following:

					LL
Interest payment					18,00,000	=Interest rate* (Debt ratio * Invested capital)
EBIT					3000000
Tax payment					480000	=Tax rate * (EBIT- Interest expense)
Net Profit after Tax					2520000	=EBIT- Tax payment
New ROE					31.50%	= Net Income/(Capital * (1- Debt ratio))