Firms HL and LL are identical except for their financialleverage ratios and the interest rates they pay on debt. Each has $20 million in investedcapital, has $4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL,however, has a debt-to-capital ratio of 50% and pays 12% interest on its debt, whereas LLhas a 30% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm usespreferred stock in its capital structure.a. Calculate the return on invested capital (ROIC) for each firm.b. Calculate the return on equity (ROE) for each firm. c. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt-to-capital ratio from 30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate the new ROE for LL.
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 $4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL,
however, has a debt-to-capital ratio of 50% and pays 12% interest on its debt, whereas LL
has a 30% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses
preferred stock in its capital structure.
a. Calculate the
b. Calculate the
c. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt-to-capital ratio from 30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate the new ROE for LL.
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