Problem:
Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $16 million in invested capital, has $2.4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 45% and pays 11% 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.
Required:
Question 1: Calculate the return on invested capital (ROIC) for each firm.
Question 2: Calculate the rate of return on equity (ROE) for each firm.
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.
Note: Could someone please give me a step by step solution?