Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $27 million in invested capital, has $5.4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 60% and pays 11% interest on its debt, whereas LL has a 40% debt-to-capital ratio and pays only 8% interest on its debt. Neither firm uses preferred stock in its capital structure.
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