Answers
The Invested capital of both HL and LL is $20 million
Debt ratio of HL is 55% and Debt ratio of LL is 25% =
Debt of HL= $11 million Debt of LL = $5 million
So, Equity of HL = Total capital - Debt (as there is no preferred stock)
= 20-11 = $ 9 million
So, Equity of LL = Total capital - Debt (as there is no preferred stock)
= 20-5 = $ 15 million
a) ROIC = Net operating profit after tax/ Invested Capital
= EBIT * (1- tax rate ) / Invested capital
As both firms have same EBIT, Tax rate and Invested capital
ROIC (HL) = ROIC (LL) = 4 * (1-0.4)/ 20 = 0.12 = 12.00%
ROE is calculated as , ROE = Profit after tax / Equity
Profit after tax calculation is done as shown in table below
| All figures in $ million | |||
| HL | LL | New LL | |
| Invested Capital | 20 | 20 | 20 |
| - Debt | 11 | 5 | 12 |
| - Equity | 9 | 15 | 8 |
| EBIT | 4 | 4 | 4 |
| Interest | 1.21 | 0.45 | 1.8 |
| EBT | 2.79 | 3.55 | 2.2 |
| Tax | 1.116 | 1.42 | 0.88 |
| PAT | 1.674 | 2.13 | 1.32 |
So, ROE (HL) =1.674/9 = 0.186 = 18.60%
ROE (LL) = 2.13/15 =0.142 = 14.20%
New ROE of LL (with changed capital structure) is also calculated in the table above
ROE (LL) = 1.32/8 = 0.1650 = 16.50%
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