Question: 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, $4 million of EBIT, and is in the 40 percent federal-plus-state tax bracket. Firm HL, however, has a debt ratio (D/A) of 50 percent and pays 12 percent interest on its debt, whereas LL has a 30 percent debt ratio and pays only 10 percent interest on 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 percent, even though that would increase LL’s interest rate on all $0 15 percent. Calculate the new ROE for LL.

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