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

Question

Seattle Health Plans currently use zero debt financing. Its operating profit is $ 1 million, and it pays taxes at a 40% 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 equality with debt financing that bears an interest rate of 8%.

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

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

c. Repeat the analysis for part a, but not assume that Seattle Health Plan is a not-for- profit and hence pays no taxes. Compare the results with those obtained in part a.

Explanation / Answer

Answer:

Old capital structure:

New capital structure:

b) With debt cost @15%:

c)

$ a) Total Capital 5000000 Equity (100%) 5000000 $ Operating profit 1000000 Tax @ 40% 400000 Net income 600000 Total Dollar return to investors 600000 ROE(Net income/Equity) 0.12 ($600,000/$5,000,000)

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