Seattle Health Plans currently uses zero dept financing. Its operating income (E

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.

Explanation / Answer

Solution:

a) With 50% debt levels, the new capital structure will be 50:50, the value of debt will be $5 million @ 8%, so the interest expense will be $0.4 million.

Amount in Millions

Operating Profit: $1

Less: interest expense 0.08

Profit before tax 0.92

Less tax @40% 0.368

PAT 0.552

Return on equity 11.04%

b) Amount in Millions

Operating Profit: $1

Less: interest expense 0.15

Profit before tax 0.85

Less tax @40% 0.34

PAT 0.51

Return on equity 10.2%

c) Amount in Millions

Operating Profit: $1

Less: interest expense 0.08

Profit before tax 0.92

Less tax 0.0

PAT 0.92

Return on equity 18.4%

In part (a) the return to equity shareholders is 11.04% whereas in part c it is 18.4%, this difference in return is due to non inclusion of tax in part c because of non profit organization.

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