Seattle Health Plans currently uses zero debt financing. Its operating profit is

Question

Seattle Health Plans currently uses zero debt financing. Its operating profit is $1 million, and it pays taxes at 40 percent rate. It has $5 million in equity. Suppose the firm is considering replacing half of its equity financing that bears an interest rate of 8 percent.

What impact would the new capital structure have on the firm’s profit, total dollar return to investors, and return on equity?

Redo the analysis, but now assume that the debt financing would cost 15 percent.

Repeat the analysis required for Part a, but now assume that Seattle Health Plans is not-for-profit corporation and hence pays no taxes.Compare the results with those obtained in Part a.

Explanation / Answer

operating profit is $1 million

and it pays taxes at 40 percent rate.

It has $5 million in equity.

Now firm is considering replacing half of its equity financing that bears an interest rate of 8 percent

Now $ 5 Million equity would split in to

$ 2.5 Equity

$ 2.5 Debt

On debt we have to pay interest

$ 2.5 Million x 8 % interest

0.2 Million

Now Interste would be deductible from operating profit

$ 1 Million - $ .20 Million

Now profit = $ 0.80 Million

Now Firm Pays 40% Tax

= $ 0.80 Million – 40% of 0.80 Million

= $ 0.48 Miillion

Return on Equity = Net Income/Shareholder's Equity

ROE is expressed as a percentage and calculated as:

=0.48/2.5

=19.20 %

but now assume that the debt financing would cost 15 percent.

Repeat the analysis required for Part a, but now assume that Seattle Health Plans is not-for-profit corporation and hence pays no taxes.

$ 2.5 Equity

$ 2.5 Debt

On debt we have to pay interest

$ 2.5 Million x 15% interest

0.375 Million

Now Interste would be deductible from operating profit

$ 1 Million - $ 0.375 Million

Now profit = $ 0.625 Million

Now Firm Pays No Tax so all profit goes to equity holders

Now

Return on Equity = Net Income/Shareholder's Equity

ROE is expressed as a percentage and calculated as:

=0.625/2.5

=25%

Current Return on Equity without any Debt Financing

Firm Pays 40% Tax

= $ 1 Million – 40% of 1 Million

= $ 0.60 Miillion

Return on Equity = Net Income/Shareholder's Equity

ROE is expressed as a percentage and calculated as:

=0.60/5

=12 %

On comparing two different option we have found that If firm is in NO Tax zone then it would be better for it to choose Debt financing is the better option because Return on Equity Increase

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