Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $10 million in invested capital, has $1.5 million of EBIT, and is in the 25% 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 30% 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.

Question

Business

Ezequiel Hendrix

1 July, 01:16

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $10 million in invested capital, has $1.5 million of EBIT, and is in the 25% 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 30% 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.

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Abdullah Butler · Answer 1

0.1125 or 11.25% for each firm

Explanation:

Given that,

Each has $10 million in invested capital,

$1.5 million of EBIT

25% federal-plus-state tax bracket

ROIC for LL:

= [EBIT * (1 - tax rate) ] : invested capital

= [1.5 * (1 - 25%) ] : 10

= 0.1125 or 11.25%

ROIC for HL

= [EBIT * (1 - tax rate) ] : invested capital

= [1.5 * (1 - 25%) ] : 10

= 0.1125 or 11.25%

Therefore, the return on invested capital (ROIC) for each firm is 11.25%