Question

13.1 Seattle Health Plans currently uses zero-debt financing. Its operating income (earnings before interest and taxes, or EBIT) is $1 million, and it pays 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 Sealttle Health Plans is a not-for-profit corporation and pays no taxes. Compare the results with those obtained in Part a.

Answer 1

	Current situation
		in million	Ratio
	Equity	5	100%
	EBIT	1
	Net Income	0.6	1 x (1-0.4)	ROE	12.00%	(0.6/5)
a	New situation
		in million	Ratio
	Equity	2.5	50%
	Debt	2.5	50%
	Interest Cost	0.2	(2.5 x 8%)
	EBIT	1
	Net Income	0.48	(1-0.2)(1-0.4)	ROE	19.20%	0.48/2.5
	Net income is decreased by (0.60-0.48) = 0.12 and ROE is increased by 7.2%
b	New situation
		in million	Ratio
	Equity	2.5	50%
	Debt	2.5	50%
	Interest Cost	0.375	(2.5 x 15%)
	EBIT	1
	Net Income	0.375	(1-0.0.375)(1-0.4)	ROE	15.00%	0.375/2.5
	Net income is decreased by (0.60-0.375) = 0.225 and ROE is increased by 3%
c	EBIT	Probability	expected EBIT	Interest*	EBT	Tax@40%	Net Income
	0.5	0.2	0.1	0.2	-0.1	-0.04	-0.06
	1	0.6	0.6	0.2	0.4	0.16	0.24
	1.5	0.2	0.3	0.2	0.1	0.04	0.06
	Expected Net Income						0.24
						ROE	9.60%	0.24/2.5
	2.5 x 8% = 0.2
	After using debt financing total ROE is decreased and also risk is increased because firm has taken the leverage
d	New situation
		in million	Ratio
	Equity	2.5	50%
	Debt	2.5	50%
	Interest Cost	0.2	(2.5 x 8%)
	EBIT	1
	Net Income	0.8	(1-0.2)	ROE	32.00%	0.8/2.5
	Net income is increased by (0.80-0.60) = 0.2 and ROE is increased by 20%