Firms HL and LL are identical except for their financial leverage ratios and the interest rates they
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Question:
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $21 million in invested capital, has $3.15 million of EBIT, and is in the 25% federal-plus-state tax bracket. Both firms are small with average sales of $25 million or less during the past 3 years, so both are exempt from the interest deduction limitation. Firm HL, however, has a debt-to-capital ratio of 50% and pays 12% interest on its debt, whereas LL has a 20% debt-to-capital ratio and pays only 9% 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. ROIC for firm LL: % ROIC for firm HL: %
- Calculate the return on equity (ROE) for each firm. Round your answers to two decimal places. ROE for firm LL: % ROE for firm HL: %
- Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 20% to 60% even though that would increase LL's interest rate on all debt to 15%. Calculate the new ROE for LL. Round your answer to two decimal places.
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