13.1 Scattle Health Plans currently uses zero-debt financi taxes, or EBTT) is op
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13.1 Scattle Health Plans currently uses zero-debt financi taxes, or EBTT) is operating income (carnings before interest and ta million, and it pays taxes at a 40 percent rate. It has S in assets and, because it is all-equity financed, $5 million i Suppose the firm is considering replacing half of its equi s equity with debt financing bearing an interest rate of 8 percent, a. What impact would the new capital structure have on 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 SI million. Redo the analysis for each level of EBIT, and find the expected values for the firm's net income, total dollar returmExplanation / Answer
We are given that the company presently has $ 5million of assets (& equity), EBIT of $ 1 million and 40% tax rate. We further make an assumption that when the company adds debt to replace part of the equity, the total assets remain at $ 5million and debt is used to repay existing equity holders proportionately.
We will not calculate the Firm's net income, total dollar return to investors and ROE:
Original Scenario: Zero Debt.
EBIT = $ 1 million and Total Assets (investments) = $ 5million
Taxes = 40% or 40% * 1 million = 0.40 million
Hence Firm's net income = $ 0.60 million
Total Dollar return to investors = $ 0.60 million
ROE = 0.60/5 = 12%
Scenario A: 50% equity and 50% debt at the interest cost of 8%
EBIT = $ 1 million
Debt = $ 2.50 million & Equity = $2.50 million
Interest Cost = 2.50 million * 8% = $ 0.20 million
Thus Profit Before Tax = (1-0.20) million = $ 0.80 million
Taxes = 40% * 0.80 million = $ 0.32 million
Firm's net income = (0.80-0.32) million = $0.48 million
Total Dollar return to investors (considering only equity investors) = $ 0.48 million
ROE = 0.48/2.50 = 19.20%
Thus we see that though the aboslute amount of firm;s net profit and dollar return to equity investors reduces but the ROE improves significantly since the after tax cost of debt at [8% * (1-40%)] is lower than the original ROE of 12%
Scenario B : 50% equity and 50% debt at the interest cost of 15%
EBIT = $ 1 million
Debt = $ 2.50 million & Equity = $2.50 million
Interest Cost = 2.50 million * 15% = $ 0.375 million
Thus Profit Before Tax = (1-0.375) million = $ 0.625 million
Taxes = 40% * 0.625 million = $ 0.25 million
Firm's net income = (0.625-0.25) million = $0.375 million
Total Dollar return to investors (considering only equity investors) = $ 0.375 million
ROE = 0.48/2.50 = 15%
Thus we see that in this case also the aboslute amount of firm;s net profit and dollar return to equity investors reduces but the ROE improves over the original scenario since the cost of debt at [15% * (1-40%)] is lower than the original ROE of 12%
Scenario C: 50% equity and 50% debt at the interest cost of 8% and EBIT can be $0.50 million with probability of 20%, $1.50 million with probability of 20% and $ 1million with 60% probability.
Expected EBIT = 0.20*0.5 + 0.2*1.50 + 0.6*1 = $ 1 million . Since the expected EBIT remains at $1 million, the expected net profit, total dollar return to investors and ROE will remain same; however we will see the impact at each EBI level separately as below:
EBIT = 0.50 million
Interest Cost = 2.50 million * 8% = $ 0.20 million
Thus Profit Before Tax = (0.50-0.20) million = $ 0.30 million
Taxes = 40% * 0.30 million = $ 0.12 million
Firm's net income = (0.30-0.12) million = $0.18 million
Total Dollar return to investors (considering only equity investors) = $ 0.18 million
ROE = 0.48/2.50 = 7.20%
Hence we can see that if the gross return on the assets falls below the cost of the debt, then the impact on the equity returns will be magnified on the negative side also.
Now we see when EBIT is $1.5 million:
EBIT = 1.50 million
Interest Cost = 2.50 million * 8% = $ 0.20 million
Thus Profit Before Tax = (1.50-0.20) million = $ 1.30 million
Taxes = 40% * 1.30 million = $ 0.52 million
Firm's net income = (1.30-0.52) million = $0.78 million
Total Dollar return to investors (considering only equity investors) = $ 0.78 million
ROE = 0.48/2.50 = 31.20%
Hence we can see that debt can help in improving the ROE but at the same it also increases the risk profile since when the firm does not perform well enough to cover for the post tax debt cost, its return will fall more than what they would have if there was no equity.
Scenario D: 50% equity and 50% debt at the interest cost of 8% and with tax rate as zero since it is not for profit firm.
EBIT = $ 1 million
Debt = $ 2.50 million & Equity = $2.50 million
Interest Cost = 2.50 million * 8% = $ 0.2 million
Thus Profit Before Tax = (1-0.2) million = $ 0.8 million
Taxes = 0
Firm's net income = $0.8 million
Total Dollar return to investors (considering only equity investors) = $ 0.8 million
ROE = 0.8/2.50 = 32%
We can see that compared to Scenario A, the returns here are magnified even more since all the residual cash flows after paying debt is now (technically) available to investors .
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