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

Question

Seattle Health Plans currently uses zero-debt financing. Its operating income (EBIT) 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 %.

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

c. Return to the initial 8% interest rate. Now, assume that EBIT could be as low as $500,000 (with a probability of 20%) or as high as $1.5 million (with probability of 20%). There remains a 60% chance that EBIT would be $1 million. Redo the analysis for each level of EBIT, and find the expected values for the firm%u2019s net income, total dollar return to investors, and ROE. What lesson about capital structure and risk does this illustration provide?

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%

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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%

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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%

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