Southwest Physicians, a medical group practice, is just being formed. It will ne

Question

Southwest Physicians, a medical group practice, is just being formed. It will need $2 million of total
assets to generate $3 million in revenues. Furthermore, the group expects to have a profit margin of 5
percent. The group is considering two financing alternatives. First, it can use all-equity financing by
requiring each physician to contribute his or her pro rata share. Alternatively, the practice can finance
up to 50 percent of its assets with a bank loan. Assuming that the debt alternative has no impact on the
expected profit margin, what is the difference between the expected ROE if the group finances with 50
percent debt versus the expected ROE if it finances entirely with equity capital?

Explanation / Answer

Initial investment = $2 million Revenues = $3 million Profit margin = 5%, therefore, net profit = $3million x 5% -> $150,000 1st financing option = All-equity financing (shareholder’s equity = $2 million) 2nd financing option = 50% by bank loan (debt) and 50% by equity. (Total debt = $1 million & shareholder’s equity = $1 million) Assumption: Debt alternative has no impact on expected profit margin Assumption: 100% dividend pay-out ratio ROE = Net income available to equity shareholders/Average shareholder’s equity x 100 1st financing option ROE = $150,000/$2 million x 100 -> 7.5% 2nd financing option ROE = $150,000/$1 million x 100 -> 15% Difference in ROE = 15%-7.5% -> 7.5%

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