Question

Check My Work (3 remaining) eBook Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $29 million in invested capital, has $4.35 million of EBIT, and is in the 25% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 45% and pays 12% interest on its debt, whereas LL has a 25% 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: ROIC for firm HL: % % b. Calculate the rate of return on equity (ROE) for each firm. Round your answers to two decimal places. ROE for firm LL: ROE for firm HL: c. Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 25% 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. Check My Work (3 remaining) Icon Key

Answer 1

Total Capital EAT Debt to Capit Total Debt Total Equity (total capital al (total capital- *debt to capi Ratio P total debt) tal ratio) 0.45 1305000015950000 0.25 7250000 21750000 ROIC EAT after (EAT after divi ROE dividends Idends/total (EAT/Total e apital) quity) 2088000 0.072 0.13090909 2827500 0.0975 0.13 HL LL 29000000 29000000 2088000 2827500 HL 4350000 LL 4350000 1566000 580000 EBIT -Interest (total debt*inte rest on debt i. e. 12% & 8%) EBT -Тах (EBT+0.25) EAT -Dividends EAT after dividends 27840003770000 696000 942500 2088000 0 2827500 2088000 2827500 Revised Calculations 29000000 0.6 17400000 Total Capital Debt to capital ratio Total debt (total capital* debt to capita I ratio) Total Equity (total capital-t otal debt) EBIT Interest (total debt*0.1 11600000 4350000 2610000 1740000 EBT -Тах (EBT+0.25) EAT ROE (EAT/total equ ity) 435000 1305000 0.1125

(Note: It is assumed that, debt to capital ratio is revised by keeping the total capital same, i.e. by raising debt and buying back equity.)

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