Question

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $23 million in invested capital, has $3.45 million of EBIT, and is in the 25% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 50% and pays 12% 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. Round your answers to two decimal places.

Answer 1

Answer:

ROIC for firm HL = 11.25%

ROIC for firm LL = 11.25%

Explanation:

Given:

EBIT = $3,450,000

Tax rate = 25%

Invested capital = $23,000,000

Note that the information above is the same for both firms HL and LL. This implies that their ROIC will be the same as calculated below:

ROIC = (EBIT * (100% - Tax rate)) / Invested capital ……………………. (1)

Substituting the values into equation (1), we have:

ROIC = ($3,450,000 * (100% - 25%)) / $23,000,000 = 0.1125, or 11.25%

Therefore, we have:

ROIC for firm HL = 11.25%

ROIC for firm LL = 11.25%