Question

Texas health plans currently use zero-debt financing. Its operating income (earnings before interest & taxes or EBIT) is $1 million, it pays taxes at 40% rate. It has $5 million in assests & because all its equity is financede, $5 million in equity. Suppose the firm is considering replacing half of its equity financing with debt financing bearing an interst 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 asume that the debt financing would cost 15%?

(c) return to the initial 8% interst rate. Now assume that EBIT could be as low as $500,000 (with probability of 20%) or as high as $1.5 million (with probability of 20%). There remains a 60% chance that EBIT would be $1 million. Redo the analysis for each level of EBIT, & find the expected values for the firm's net income, total dollar return to investors & ROE. What lession about capital structure and risk does this illistration provide?

Answer 1

a)

All Equity                      50% Debt

Balance Sheets:

          Current assets                         $5,000,000                    $5,000,000

          Fixed assets                                      $                 0                           $                0

          Total assets                             $5,000,000                    $5,000,000

                                                         

          Bank loan (8% Cost)                        $                 0                           $2,500,000

          Common stock                        $5,000,000                    $2,500,000

          Total liabilities and equity                $5,000,000                    $5,000,000

                                                         

Income Statements:

          Revenues                                 $6,000,000                    $6,000,000

          Operating costs                       $5,000,000                    $5,000,000

                   Operating income          $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                              $   600,000                    $480,000

                                                         

          ROE                                        12 % (600,000/5,000,000) p.449    19.2%                             

          Total dollar return to investors         $600,000                       $680,000

b)

All Equity                                      50% Debt

Balance Sheets:

          Current assets                         $5,000,000                              $5,000,000

          Fixed assets                                      $                 0                                     $                 0            

          Total assets                             $5,000,000                              $5,000,000   

                                                         

          Bank loan (15% Cost)             $                 0                                     $2,500,000   

          Common stock                        $5,000,000                              $2,500,000   

          Total liabilities and equity                $5,000,000                              $5,000,000   

                                                         

Income Statements:

          Revenues                                 $6,000,000                              $6,000,000   

          Operating costs                       $5,000,000                              $5,000,000   

                   Operating income          $1,000,000                              $1,000,000        

          Interest expense                       $                 0                                     $    375,000            

                   Taxable income              $1,000,000                              $    625,000            

          Taxes (40%)                                      $   400,000                              $    250,000            

         

Net income                              $   600,000                              $   750,000

ROE                                        12 % (600,000/5,000,000) p.449                                   15%                             

          Total dollar return to investors         $600,000                                 $    750,000

c)

EBIT $500,000    EBIT $1.5 mill     All Equity

Balance Sheets

          Current assets                         $5,000,000           $5,000,000      $5,000,000

          Fixed assets                                      $                 0                 $                 0             $                 0

          Total assets                             $5,000,000           $5,000,000      $5,000,000

                                                         

          Bank loan (8% Cost)                        $                 0                 $2,500,000      $                 0

          Common stock                        $5,000,000           $2,500,000      $5,000,000

          Total liabilities and equity                $5,000,000           $5,000,000      $5,000,000

                                                         

Income Statements:

          Revenues                                 $5,500,000           $6,500,000      $6,000,000

          Operating costs                       $5,000,000           $5,000,000      $5,000,000

                   Operating income          $   500,000           $1,500,000      $1,000,000

          Interest expense                       $                 0                 $                 0             $                 0

                   Taxable income              $   500,000           $1,500,000      $1,000,000

          Taxes (40%)                                      $   200,000           $   600,000      $   400,000

         

          Net income                              $   300,000           $900,000         $   600,000

                             ROE                                        6 % (600,000/5,000,000)        18%                 12%

          Total dollar return to investors         $300,000              $900,000         $   600,000

Lession:-

When debt is utilized the operating income will be higher leading to higher ROE.