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