Question

Seattle Health Plans currently use zero-debt financing. It's operating income (EBIT) is $1 million, and it pays taxes at a 40% rate. It had $5 million in assests, 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 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%

C. Return to the initial 8% interest rate. Now assume that EBIT could be as low as %500,000 or as high as $1.5 million. There remain a 60% chance that EBIT would be $1 million.

D. Repeat the analysis required for part a, but now assume that Seattle Health Plan is a not-for-profit corporation and pays no taxes. Compare the results with those obtained in Part a.

Answer 1

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

We can see from the calculations that the firm's net income from the new capital structure and old capital structure.

The net income is reduced because of the interest cost in the new capital structure.

But the overall ROE has increased from 12% (without leverage) to 19.2% (with leverage). So it is clearly evident that by including the leverage of 50% debt financing the overall return of the investor is inceasing.

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

Now here if we make the cost of debt as 15%, the interest cost will increase

New Interest cost = 15% * 2,500.000 = $375,000

EBIT = $1,000,000

Less Interest = $ 375,000

EBT $625,000

Less: Tax (40%) $250,000

Net Income $375,000

ROE = 375000/250000 = 0.15 or 15%

Now we can see that the ROE has decreased from 19.2% to 15%. It is an impact in the cost of financing. Still the ROE is greater than 100% equity financing.

C. Return to the initial 8% interest rate. Now assume that EBIT could be as low as %500,000 or as high as $1.5 million. There remain a 60% chance that EBIT would be $1 million.

Taking into consideration probability of 60% EBIT would be 1 million, so rest 20% chance is that EBIT would be 500000 and 20% chancce that EBIT would be 1.5 million.

We can see from the above analysis where the EBIT has been considered at $500000 and $1.5 million

EBIT = (20% * $500,000) + (20% * $1.5 million) + (60% * $1 million) = $1 million

The analysis for $1 million is already done above.

D. Repeat the analysis required for part a, but now assume that Seattle Health Plan is a not-for-profit corporation and pays no taxes. Compare the results with those obtained in Part a.

Since it doesnt pay tax, please find below the new analysis in the jpg file