Seattle health plans currently uses zero debt financing. Its operating income is

Question

Seattle health plans currently uses zero debt financing. Its operating income 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 equity financing with debt financing bearing an interest rate of 8%.

ONLY part d requested

A. What impact would the new capital structure have on the firms net income, total dollar rerun to investors and ROE?

D. Repeat the analysis in part A but now assume that Seattle health plans is a not for profit corp. and pays no taxes.

Explanation / Answer

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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