Question

Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $25 million in invested capital, has $5 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 55% and pays 11% interest on its debt, whereas LL has a 20% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure. Calculate the return on invested capital (ROIC) for each firm. Round your answers to two decimal places.

1) ROIC for firm LL is %
2) ROIC for firm HL is %

Answer 1

The ROIC for firm LL is 12.80%, while the ROIC for firm HL is 14.42%. The calculations are based on the NOPAT, which takes into account the EBIT, interest expenses on debt, and tax savings.

Step-by-step explanation:

To calculate the Return on Invested Capital (ROIC) for each firm, we consider both EBIT and the tax savings from the interest expense. ROIC is calculated as Net Operating Profit After Taxes (NOPAT) divided by the Invested Capital. Here, Invested Capital is equal for both firms at $25 million.

For firm LL, which has a 20% debt-to-capital ratio and pays 10% interest:

• Interest = Debt x Interest rate = $25M x 20% x 10% = $0.5M
• EBIT = $5M
• Taxes = (EBIT - Interest) x Tax rate = ($5M - $0.5M) x 40% = $1.8M
• NOPAT = EBIT - Taxes = $5M - $1.8M = $3.2M
• ROIC for firm LL = NOPAT / Invested Capital = $3.2M / $25M = 12.80%

For firm HL, with a 55% debt-to-capital ratio paying 11% interest:

• Interest = Debt x Interest rate = $25M x 55% x 11% = $1.5125M
• Taxes = (EBIT - Interest) x Tax rate = ($5M - $1.5125M) x 40% = $1.395M
• NOPAT = EBIT - Taxes = $5M - $1.395M = $3.605M
• ROIC for firm HL = NOPAT / Invested Capital = $3.605M / $25M = 14.42%