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%.

A. What impact would the new capital sturcture have on the firm's income, total dollar return to investors, and ROE?

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 probibility of 20%) or as high as $1.5 million (with a probibility 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'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

SEATTLE HEALTH: Present situation (All Equity firm) EBIT 1000000 Tax at 40% 400000 NI 600000 Assets 5000000 Equity 5000000 Debt 0 Total dollar return to investors 600000 ROE = NI/Equity = 12.00% A) New capital structure, with 8% Cost of debt: EBIT 1000000 Interest (2500000*8%) 200000 Income before tax 800000 Tax at 40% 320000 NI 480000 Assets 5000000 Equity 2500000 Debt 2500000 Total dollar return to investors = 480000+200000 = 680000 ROE = NI/Equity = 19.20% Impact: Introduction of debt increases total return to investors (equity and debt) and also increases ROE. B) New capital structure. With 15% Cost of debt: EBIT 1000000 Interest (2500000*15%) 375000 Income before tax 625000 Tax at 40% 250000 NI 375000 Assets 5000000 Equity 2500000 Debt 2500000 ROE = NI/Equity = 15.00% C) EBIT 500000 1000000 1500000 Interest (2500000*8%) 200000 200000 200000 Income before tax 300000 800000 1300000 Tax at 40% 120000 320000 520000 NI 180000 480000 780000 Probability 0.2 0.6 0.2 Expected NI = 180000*.2+480000*.6+780000*.2 = 480000 Total dollar return to investors = 480000+200000 = 680000 ROE = NI/Equity = 480000/2500000 = 19.20% LESSON: Addition of debt would increase ROE due to the effect of financial leverage. Additional debt would imply higher risk. This means that higher ROE is associated with higher financial leverage and hence higher risk. D) New capital structure, with 8% Cost of debt and no taxes: EBIT 1000000 Interest (2500000*8%) 200000 Income before tax 800000 Tax at 0% 0 NI 800000 Assets 5000000 Equity 2500000 Debt 2500000 Total dollar return to investors = 200000+800000 = 1000000 ROE = NI/Equity = 32.00% The ROE is more without taxes.

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