Firms ABC and XYZ are identical except for the financial leverage ratios and the interest ratios they pay on debt. Each has 20 million in invested capital, has $4 million on EBIT and in the 40% state tax bracket. Firm ABC however has a debt-to-capital ratio of 50% and pays 12% interest on its debt, whereas XYZ has a 30% debt-to-capital ratio of 50% and pays 10% interest on its debt. Neither firm uses preferred stock in its capital structure
a. Calculate the return investment capital (ROIC) for each firm.
b. Calculate the return on equity (ROE) for each firm?
c. Observing that the ABC has a higher ROE, XYZ's treasurer is thinking of raising the debt-to-capital ratio form 30%to 60% even though that would increase XYZ interest rate on all debt to 15%. Calculate the new ROE for XYZ.