Seattle Health Plans currently uses zero-debt financing. Its operating income (E
ID: 2771705 • Letter: S
Question
Seattle Health Plans currently uses zero-debt financing. Its operating income (EBIT) is $1 million, and it pays taxes at a 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 remains a 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 Seattle Health Plans is a not-for-profit corporation and pays no taxes. Compare the results with those obtained in Part a.
Explanation / Answer
a)
Net Income would come down on account of but ROE would improve on account of lesser shareholding.
b. ROE would come down if debt financing would cost 15%.
c. EBIT at 500000.
If the EBIT falls to $ 500000, the overall advantage of financial leverage goes away as the earnings available goes on to service the debt and hence, ROE becomes too low in comparison to not taking debt at all.
d).
The moment taxes are removed, ROE under all equity financing does improve by 8% but on the other side, ROE under equity and debt financing improves several times high from 19% to 32% on account of taking advantage of financial leverage which magnifies the returns to equity shareholders.
Details All Equity financing Equity + Debt Financing EBIT 1000000 1000000 Interest 0 200000 PBT 1000000 800000 Tax @40% 400000 320000 Net Income 600000 480000 Return on Equity 12% 19%Related Questions
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