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Fundamentals of Financial Manageme...
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Fundamentals of Financial Manageme...
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 $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 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.
a
To identify: The return on invested capital.
Introduction:
Return on Invested Capital:
The return on invested capital refers to the rate at which the company is able give the return to its shareholders and bondholders in respect to the net income.
Given information:
The EBIT is $4 million.
The total capital is $20 million.
The tax rate is 40%.
Formula to calculate the return on invested capital,
Where,
- EBIT is earning before interest and tax.
Substitute $4,000,000 for EBIT, 40% for tax and $20,000,000 for total capital.
b.
To identify: The return on equity of the firm.
Introduction:
Return on Equity:
The return on equity refers to the rate at which the company is able give the return to its shareholder in respect of the net income.
c.
To identify: The return on equity.
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