The firms HL and LL are identical except for their debt-to-total-assets ratios and interest rates on debt. Each has $20 million in assets, earned $4 million before interest and taxes, and has a 40 percent marginal tax rate. Firm HL, however, has a debt-to-total-assets ratio (D/TA) of 50 percent and pays 12 percent interest on its debt, whereas LL has a 30 percent debt-to-total-assets ratio and pays only 10 percent interest on debt.

a. Calculate the rate of return on equity (net income/equity) for each firm.

b. Observing that HL has a higher return on equity, LL’s treasurer decides to raise the debt-to-total-assets ratio from 30 to 60 percent, which will increase LL’s interest rate on all debt to 15 percent. Calculate the new ROE for LL. ROE = (Net income)/(Common equity).