Seattle Health Plans currently uses zero dept financing. Its operating income (E
ID: 1171726 • Letter: S
Question
Seattle Health Plans currently uses zero dept financing. Its operating income (EBIT) is $1 million, and it pays taxes at 40 percent rate. It has $5 million in assets and, because it is all equity financed, $ 5 million in equity. Suppose the firm is considering replacing half of its equity financing with debt financing bearing an interest rate of 8 percent. a. What impact would the new capital structure have on the firm's net income, total dollar return to investors, and ROE? B. Redo the analysis, but now assume that the debt financing would cost 15 percent. C. Return to the initial 8 percent interest rate. Now, assume that EBIT could be as low as $500,000 (with a probability of 20 percent). There remsind s 60 percent chance that EBIT would be $1 million. Redo the analysis for each level of EBIT, and find the expected values for the firm's net income, total dollar return to investors, and ROE. What lesson about capital structure and risk does this illustration provide? D. Repeat the analysis required for Part a, but now assume that Settle Health Plans is a not for profit corporation and pays no taxes. Compare the results with those obtained in Part a. Seattle Health Plans currently uses zero dept financing. Its operating income (EBIT) is $1 million, and it pays taxes at 40 percent rate. It has $5 million in assets and, because it is all equity financed, $ 5 million in equity. Suppose the firm is considering replacing half of its equity financing with debt financing bearing an interest rate of 8 percent. a. What impact would the new capital structure have on the firm's net income, total dollar return to investors, and ROE? B. Redo the analysis, but now assume that the debt financing would cost 15 percent. C. Return to the initial 8 percent interest rate. Now, assume that EBIT could be as low as $500,000 (with a probability of 20 percent). There remsind s 60 percent chance that EBIT would be $1 million. Redo the analysis for each level of EBIT, and find the expected values for the firm's net income, total dollar return to investors, and ROE. What lesson about capital structure and risk does this illustration provide? D. Repeat the analysis required for Part a, but now assume that Settle Health Plans is a not for profit corporation and pays no taxes. Compare the results with those obtained in Part a.Explanation / Answer
A.Impact of New Capital Structure on the firm's net income, total dollar return to investors, and ROE:
Before Debt Financing
After Debt Financing
EBIT
1000,000
1000,000
Less: Interest
-
200,000
EBT
1000,000
800,000
Less: Taxes@40%
400,000
320,000
EAT
600,000
480,000
Equity
5000,000
2500,000
Earning per $ of Equity
0.12
0.192
ROE
12%
19.2%
Total $ return to investors have reduced from 600,000 to 480,000
But since the equity has declined, ROE has increased from 12% to 19.2%
B.Cost of Debt Financing is 15%
Before Debt Financing
After Debt Financing
EBIT
1000,000
1000,000
Less: Interest
-
375,000
EBT
1000,000
625,000
Less: Taxes@40%
400,000
250,000
EAT
600,000
375,000
Equity
5000,000
2500,000
Earning per $ of Equity
0.12
0.15
ROE
12%
15%
Total $ return to investors have reduced from 600,000 to 375,000
But since the equity has declined, ROE has increased from 12% to 15%
C.Comparison
02 Probability
0.6 Probability
EBIT
500,000
1000,000
Less: Interest
200,000
200,000
EBT
300,000
800,000
Less: Taxes@40%
120,000
320,000
EAT
180,000
480,000
Equity
2500,000
2500,000
Earning per $ of Equity
0.072
0.192
ROE
7.2%
19.2%
With 100% increase in profits, ROE has increased by more than 100%. This is known as trading on Equity i.e. the benefit of having a leveraged capital structure.
D.Part A without Taxes
Before Debt Financing
After Debt Financing
EBIT
1000,000
1000,000
Less: Interest
-
200,000
EBT
1000,000
800,000
Less: Taxes
NIL
NIL
EAT
1000,000
800,000
Equity
5000,000
2500,000
Earning per $ of Equity
0.2
0.32
ROE
20%
32%
Higher Increase in ROE after debt financing when there are no taxes, because of higher income for Equity.
Before Debt Financing
After Debt Financing
EBIT
1000,000
1000,000
Less: Interest
-
200,000
EBT
1000,000
800,000
Less: Taxes@40%
400,000
320,000
EAT
600,000
480,000
Equity
5000,000
2500,000
Earning per $ of Equity
0.12
0.192
ROE
12%
19.2%
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