Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $10 million in invested capital, has $1.5 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 13% interest on its debt, whereas LL has a 20% debt-to-capital ratio and pays only 9% interest on its debt. Neither firm uses preferred stock in its capital structure.
ROIC = Net operating profit after tax / Total capital
Net operating profit after tax = EBIT (1- Tax rate)
a) Total capital = $10 million
EBIT = $1.5 million
Tax rate = 40%
EBIT (1- Tax rate) = $1,500,000(1-0.4) = $900,000
ROIC= $900,000 / $10,000,000 = 0.09 = 9% for both LL and HL.
c) ROE= Net income / Shareholder's equity
HL: Net Income = EBIT(1- interest rate) (1- tax rate)
Net income= $1,500,000(1-0.13)(1-0.4) = $783,000
Total capital = $10million
Debt-to-capital ratio= 0.6
Hence equity is $4 million.
ROE = $783,000 / $4,000,000 = 0.19575 = 19.57%
d) LL: Net Income = EBIT(1- interest rate) (1- tax rate)
Net income= $1,500,000(1-0.09)(1-0.4) = $819,000
Total capital = $10million
Debt-to-capital ratio= 0.2
Hence equity is $8 million.
ROE = $819,000 / $8,000,000 = 0.1023575 = 10.24%
e) By plugging in the required interest rate and debt to capital ratio for LL:
LL: Net Income = EBIT(1- interest rate) (1- tax rate)
Net income= $1,500,000(1-0.15)(1-0.4) = $765,000
Total capital = $10million
Debt-to-capital ratio= 0.6
Hence equity is $4 million.
ROE = $765,000 / $4,000,000 = 0.19125 = 19.125% ~ 19.13%
Firms HL and LL are identical except for their financial leverage ratios and the interest rates...
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