Question

XYZ Health Organization has a division that currently uses zero debt financing. Assume that the operating income (EBIT) is 1,000,000 SAR. Assume that the firm has 5,000,000 SAR in Assets with an equal amount in equity (because it currently has no debt). The firm wants to expand its product offerings and is considering replacing half of its equity financing with debt financing at an interest rate of 8%. The corporate tax rate is 20%. Assume that you are the Chief Financial Officer of the organization.

1. Determine how the new capital structure would impact the firm’s net income, total dollar return to investors, and ROE?
2. Conduct the analysis again but assume that the cost of debt has risen to 15%?
3. Then using the original 8% interest rate, assume that annual EBIT has dropped to 500,000 SAR or could go as high as 1.5 million SAR (both with a probability of 20%). While there is a 60% chance that EBIT will remain 1,000,000 SAR. Redo the analysis for each level of EBIT and determine the expected values for the division’s net income, total dollar return to investors, and ROE.

After you have conducted all the calculations, make recommendations to the company as to which avenue the company should take. Consider what you have learned about the healthcare needs under SV2030 as well as your knowledge of the healthcare industry.

Answer 1

a) Calculation are in SAR million

Particulars	No Debt	With Debt
EBIT	1	1
Less - Interest	-	0.2
EBT	1	0.8
Less - Tax	0.20	0.16
PAT (Net income)	0.80	0.64
Total Investment	5	5
Dollar return to inv	16.00%	12.80%
Equity	5	2.5
ROE	16.00%	25.60%

The firms total net income will reduce marginally but adding debt in the capital structure.

b) If the cost of debt is 15% -

Particulars	No Debt	With Debt @ 15%
EBIT	1	1
Less - Interest	-	0.38
EBT	1	0.63
Less - Tax	0.20	0.13
PAT (Net income)	0.80	0.50
Total Investment	5	5
Dollar return to inv	16.00%	10.00%
Equity	5	2.5
ROE	16.00%	20.00%

C)

Particulars	Option1	Option 2	Option 3
Probability	20%	20%	60%
EBIT	0.50	1.50	1.00
Less - Interest	0.20	0.20	0.20
EBT	0.30	1.30	0.80
Less - Tax	0.06	0.26	0.16
PAT (Net income)	0.24	1.04	0.64
Total Investment	5.00	5.00	5.00
Dollar return to inv	0.05	0.21	0.13
Equity	2.50	2.50	2.50
ROE	10%	42%	26%

basis the calculation and keeping in mind health industry, it is advisable to go for debt structure as it would help to increase equity shareholders return. Also, it would lead to a decrease in net income however the overall share holders return will increase. This would keep the shareholders happy as they have maximised their return. Also there would be dilution of control as well.