Question

Seattle Health Plans currently uses zero-debt financing. Its operating income (earnings before interest and taxes, or EBIT) is $1 million, and it pays taxes at a 40 percent rate. It has $5 million in assets 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 percent.

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 percent.

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

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

Answer 1

Current structure
Assets	Liability
5,000,000	0
	Equity
	5,000,000
Tax rate	40%
EBIT	1,000,000
Tax	400,000	=1.000,000*40%
PAT	600,000
a
Proposed structure
Assets	Liability
5,000,000	2,500,000
	Equity
	2,500,000
Interest rate	8%
Interest liability	200,000	=8%*2,500,000
EBIT	1,000,000
Less interest	200,000
PBT	800,000
Tax	320,000	=800,000*40%
PAT	480,000
b
Interest rate	15%
Interest liability	375,000	=15%*2,500,000
EBIT	1,000,000
Less interest	375,000
PBT	625,000
Tax	250,000	=625,000*40%
PAT	375,000

We calculate return parameters in base case, 8% interest and 15%. Note than investors comprise of both debt and equity investors. The returns to investors will comprise of PAT and interest payment

Net Income	$ return to investors	ROE
600,000	600,000	12.00%
480,000	680,000	19.20%
375,000	750,000	15.00%

We see that as the interest rate increased, the $ return to investors increased. This because of the tax advantage or tax shield. Since interest payment is tax deductible, the total interest paid is lower in case of higher interest rate. Hence, the total return to investors increases. The return to equity holders (ROE) however, decreases as the interest payment increases.

c
Calculating returns for different EBIT scenarios

Interest rate	8%		Interest rate	8%		Interest rate	8%
Interest liability	200,000		Interest liability	200,000		Interest liability	200,000
EBIT	500,000		EBIT	1,500,000		EBIT	1,000,000
Less interest	200,000		Less interest	200,000		Less interest	200,000
PBT	300,000		PBT	1,300,000		PBT	800,000
Tax	120,000		Tax	520,000		Tax	320,000
PAT	180,000		PAT	780,000		PAT	480,000

Net Income	$ return to investors	% change	ROE	% change	Probability	Weighted return to investors	Weighted ROE
180,000	380,000	-44.1%	7.20%	-62.5%	20%	76,000	1.44%
780,000	980,000	44.1%	31.20%	62.5%	20%	196,000	6.24%
480,000	680,000	0.0%	19.20%	0.0%	60%	408,000	11.52%
					Total	680,000	19.20%

The expected return (probability weighted return) under the 3 scenarios is 680,000 to investors and expected ROE is 19.2%. We can see that when EBIT dropped by 50% to 500,000 the ROE dropped by 62.5% and when the EBIT increased by 50%, the ROE increased by 62.5%. The return to debt holders was fixed i.e. the interest payment of 200,000. The additional debt (leverage or gearing) creates a gearing effect on the returns to equity providers. The profits as well as the losses are magnified with debt.

d

Tax	40%		Tax	0%		Tax	40%
Assets	Liability		Assets	Liability		Assets	Liability
5,000,000	2,500,000		5,000,000	2,500,000		5,000,000	-
	Equity			Equity			Equity
	2,500,000			2,500,000			5,000,000
Interest rate	8%		Interest rate	8%		Interest rate	8%
Interest liability	200,000		Interest liability	200,000		Interest liability	-
EBIT	1,000,000		EBIT	1,000,000		EBIT	1,000,000
Less interest	200,000		Less interest	200,000		Less interest	-
PBT	800,000		PBT	800,000		PBT	1,000,000
Tax	320,000		Tax	-		Tax	400,000
PAT	480,000		PAT	800,000		PAT	600,000

Net Income	$ return to investors	ROE
480,000	680,000	19.20%
800,000	1,000,000	32.00%
600,000	600,000	12.00%

When we compare the case where we had 40% tax rate vs. 0 tax liability, we see that the total returns to investors as well as the ROE has increased by 66.7% (=32%/19.2%) or 320,000. This is the exact amount paid as tax.