13-5 Financial Leverage Effects Firms HL and LL are identical except for their leverage ratios and..

13-5 Financial Leverage Effects Firms HL and LL are identical except for their leverage ratios and..

13-5 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 assets, has $4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt ratio (D/A) of 50% and pays 12% interest on its debt, whereas LL has a 30% debt ratio and pays only 10% interest in its debt. a. Calculate the rate of return on equity (ROE) for each firm b. Observing that HL has a higher ROE, LLs treasurer is thinking of raising the debt ratio from 30% to 60% even though that would increase LLs interest rate on all debt to 15%. Calculate the new ROE for LL. 13-8 Cyclone Software Co. is trying to estimate its optimal capital structure. Cyclones current capital structure consists of 25% debt and 75% equity, however, management believes the firm should use more debt. The risk free rate is 5%, the market risk premium is 6% and the firms tax rate is 40%. Currently, Cyclone cost of equity is 14%, which is determined on the basis of the CAPM. What would be the estimated cost of equity if it were to change its capital structure from its present capital structure to 50% debt and 50% equity?

13-5

 

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 assets, has $4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt ratio (D/A) of 50% and pays 12% interest on its debt, whereas LL has a 30% debt ratio and pays only 10% interest in its debt.

1. Calculate the rate of return on equity (ROE) for each firm
2. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt ratio from 30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate the new ROE for LL.

 

 

13-8

 

Cyclone Software Co. is trying to estimate its optimal capital structure.  Cyclone’s current capital structure consists of 25% debt and 75% equity, however, management believes the firm should use more debt.  The risk free rate is 5%, the market risk premium is 6% and the firm’s tax rate is 40%.  Currently, Cyclone cost of equity is 14%, which is determined on the basis of the CAPM.  What would be the estimated cost of equity if it were to change its capital structure from its present capital structure to 50% debt and 50% equity?

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