Financial Leverage effects. Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $20 million in assests, has $4 million of EBIT, and is in the 40% federal-plus-state-tax bracket. Firm HL, however, has a debt ratio and pays only 10% interest on its debt.
- Calculate the rate of return on equity(ROE) for each firm.
: D/TA = 30%.
EBIT $4,000,000
Interest ($6,000,000 ´ 0.10) 600,000
EBT $3,400,000
Tax (40%) 1,360,000
Net income $2,040,000
Return on equity = $2,040,000/$14,000,000 = 14.6%.
HL: D/TA = 50%.
EBIT $4,000,000
Interest ($10,000,000 ´ 0.12) 1,200,000
EBT $2,800,000
Tax (40%) 1,120,000
Net income $1,680,000
Return on equity = $1,680,000/$10,000,000 = 16.8%.
