Keep the cost of debt financing at 8% as presented below, assume instead that th
ID: 2775673 • Letter: K
Question
Keep the cost of debt financing at 8% as presented below, assume instead that the healthcare organization is a not-for-profit corporation and hence pays no taxes.
Find the Return on Equity (ROE) for the 50% stock/50% debt capital structure only.
(Otherwise said, redo the analysis here for the righthand column while assuming no federal income tax provision)
The key points in the data are (1) the use of debt financing leverages up ROE from 12.0% to 19.2%, (2) Total dollars returned to investors (including both stockholders and creditors) increased from $600,000, and (3) the “extra” $80,000 came from the “taxman”, as taxes are reduced by that amount.
Balance Sheets Stock Stock/Debt Total assets $5,000,000 $5,000,000 Debt $0 2,500,000 Common stock $5,000,000 2,000,000 Total liabilities & equity 5,000,000 $5,000,000 Income Statements EBIT $1,000,000 1,000,000 Interest expense 0 200,000 Taxable income $1,000,000 $800,000 Taxes (40%) 400,000 320,000 Net income $6,000,000 480,000 Total dollar return to $600,000 $680,000 Investors ROE 12% 19.20%Explanation / Answer
A correction has to be made first. In column 2, value of common stock should be $2,500,000 instead of $2,000,000.
Now, the health care organisation is a not for profit organization and hence pays no taxes. Capital structure is 50% equity and 50% debt. Cost of Debt Financing is 8%.
Calculations :
Now cost of debt is 8%., thus Interest expense = 8% * 2500000 = $200,000
Taxable income = EBIT - Interest = 1000000 - 200000 = $800,000
Tax rate is 0%, Therefore tax = 0% * Taxable Income = $0
Net Income = Taxable Income - Tax = 800,000 - 0 = $800,000
Total Dollar Return to the Investors = Net Income + Interest Expense = $800,000 + $200,000 = $1,000,000
Return on Equity = Net Income / Shareholder's Equity = 800000/2500000 = 32%
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