Problem: The firms HL and LL are identical except for their leverage ratios and effects of interest rates on debt. Each has $20 million in assets, earned $4 million before interest and taxes, and has a 40 percent marginal tax rate. Firm HL, however, has a leverage ratio (Debt/TA) of 50 percent and pays 12 percent interest on this debt. Firm LL has a 30 percent leverage ratio and pays only 10 percent interest on debt.
Q1. Calculate the rate of return on equity (net income/equity) for each firm.
Q2. Observing that HL has a higher return rate on equity, LL's treasurer decides to raise the firms leverage ratio from 30 percent to 60 percent, which will increase LL's interest rate on all debt to 15 percent. Calculate the new rate of return on equity for LL.