Question

Seattle Health Plans currently uses zero-debt financing. Its operating income (EBIT) is $1M, and pays 40% tax rate. It has $5M in assets (& equity). Suppose the firm is considering replacing half of its equity financing with debt @ 8%.

a. What impact would this have on NI, ROI, ROE?

b. What if SHP is a Not For Profit?

Answer 1

Zero debt financing option
EBIT	10,00,000
Less : Interest	0
Earnings before taxes	10,00,000
Less : Taxes @ 40%	4,00,000
Net Income	6,00,000
Assets	50,00,000
Equity	50,00,000
Debt	0
ROE	=600000/5000000 = 12.00%
ROA	=600000/5000000 = 12.00%
50% debt financing option @ 8%
EBIT	10,00,000
Less : Interest (2500000*8%)	2,00,000
Earnings before taxes	8,00,000
Less : Taxes @ 40%	3,20,000
Net Income	4,80,000
Assets	50,00,000
Equity (50%*5000000)	25,00,000
Debt (50%*5000000)	25,00,000
ROE	480000/2500000 = 19.20%
ROA	480000/5000000 = 9.60%
50% debt financing option @ 8% and SHP is Not for profit
EBIT	10,00,000
Less : Interest	2,00,000
Earnings before taxes	8,00,000
Less : Taxes @ 40%	0
Net Income	8,00,000
Assets	50,00,000
Equity (50%*5000000)	25,00,000
Debt (50%*5000000)	25,00,000
ROE	800000/2500000 = 32.00%
ROA	800000/5000000 = 16.00%
ROE = Net income / Equity
ROA = Net income / Total assets

a. If SHP replaces 50% equity by debt then its net income and ROA would decrease but ROE would increase

b. If SHP is not for profit then it will not pay taxes and in that case its net profit would be $800,000