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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 teasurer is thinking of raising the debt-to-capital radio from 30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate the new ROW for LL.

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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781285867977
BuyFind

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781285867977

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Section
Chapter 14, Problem 5P
Textbook Problem

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.

  1. a. Calculate the return on invested capital (ROIC) for each firm.
  2. b. Calculate the return on equity (ROE) for each firm.
  3. c. Observing that HL has a higher ROE, LL’s teasurer is thinking of  raising the debt-to-capital radio from 30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate the new ROW for LL.

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