Question

Brenton Point Health Plan currently zero-debt financing. Its operating profit is $1.5 million, and it pays taxes at a 25% rate. It has $6 million in assets and, because it is all-equity financed, $6 million in equity. Suppose the firm is considering replacing 40% of its equity financing with debt financing that carries a 5% interest rate. What impact would the new capital structure have on Brenton Point Health Plan’s a.Profit? b. Total dollar return to investors? c.Return on Equity?

Answer 1

Answer:-

Given

Operating Profit EBIT = $ 1.5 million
Tax rate = 25%
Interest expense = 0 ( as it has zero debt)
Therefore EBT = $ 1.5 million
PAT or net profit = EBT x ( 1- tax rate)
= $ 1.5 million x ( 1- 0.25)
= $ 1.5 million x 0.75
PAT or profit = $ 1.125 million

When the company replaces 40% of equity with debt
Given equity = $ 6 million
On replacing with 40% debt the debt = 0.4 x $ 6 million
= $ 2.4 million
Therefore debt = $ 2.4 million and
equity = $ 6 million - $ 2.4 million= $ 3.6 million

The new capital structure would have impact on

a) Profit
Given EBIT = $ 1.5 million
Interest expense = 5% x $ 2.4 million ( Since the debt carries 5% interest)
= 0.05 x $ 2.4 million
= $ 0.12

EBT = EBIT - Interest Expense
= $ 1.5 million - $ 0.12 m
EBT = $ 1.38 million
PAT = $ 1.38 million x ( 1- tax rate)
= $ 1.38 million x ( 1- 0.25)
PAT  = $ 1.035 million
Therefore PAT or profit decreased by $ 1.125 - $ 1.035 = $ 0.09 million under the new capital structure of 40% debt financing.

b) Total dollar return to investors

The total dollar return is completely for equity investors in the case of 100% equity financing where as in the case of 40% debt and 60% equity in the financing the dollar returns will be for debt holders and then the equity holders as the debt holders has more priority than equity holders.

c) ROE
ROE = Net income / Equity

With only equity financing
ROE = $ 1.125 m / $ 6 m
ROE = 0.1875
ROE = 18.75 %

With 40% debt financing
ROE = $ 1.035 m / $ 3.6 m
ROE= 0.2875
ROE = 28.75%