8.1 Seattle Health Plans currently uses zero debt financing. Its operating profi

Question

8.1 Seattle Health Plans currently uses zero debt financing. Its operating profit 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 that bears an interest rate of 8 percent.

a. What impact would the new capital structure have on the firm’s profit, total dollar return to investors, and return on equity?

b. Redo the analysis, but now assume that the debt financing would cost 15 percent.

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

I have seen this question being answered over and over however, the answers differ thus I am thrown off on how to actually do the problem.

Explanation / Answer

Current Net Profit = $1 mill x (1 - 0.4) = $ 0.60 mill

(a) In revised capital structure, Equity = $2.5 mill & 8% Debt = $2.5 mill

Interest on debt = $2.5 mill x 8% = $0.20 mill

So, Taxable Income will reduce by $0.20 mill.

Earning Before Taxes = Operating Profit - Interest Paid = $(1 mill - 0.20 mill) = $0.80 mill

Earning after taxes (Net Income) = $0.80 mill x (1 - 0.40) = $0.48 mill

So, Net profit has reduced by $0.12 mill (0.60 - 0.48).

Return on equity (ROE) = (Net profit / Equity employed) x 100 = $0.48 mill / $2.5 mill x 100 = 19.2%

(b) For a 15% debt, Interest paid = 15% x $2.5 mill = $0.38 mill

So, revised Earning before taxes = $1 mill - $0.38 mill = $0.62 mill

Revised Net income = $0.62 mill x (1 - 0.40) = $0.37 mill

So, Net income has reduced by $0.23 mill (0.60 - 0.37).

Return on equity (ROE) = (Net profit / Equity employed) x 100 = $0.37 mill / $2.5 mill x 100 = 14.8%

(c) Tax = 0

So, Net Income = earning before tax = $0.80 mill

Net income in case (a) = $0.48 mill

Increase in net income = $0.32 mill

ROE = $0.80 mill / $2.5 mill x 100 = 32%

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