seattle health plans currently uses zero debt financing. It\'s operating income(
ID: 2676615 • Letter: S
Question
seattle health plans currently uses zero debt financing. It's operating income(ebit) is $1 million and it pays taxes at a 40 percent rate. it has $5 million in assests and because is it all equity financed, $5 million in equity. suppose the firm is considering replacing half of its equity financing with debt financing bearing an interst 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(wiwith a probability of 20 percent) or as high as $1.5 million(with a probability of 0 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 a not for profit corporaton and pays no taxes. compare the results with those obtained in part a.
Explanation / Answer
a) With 50% debt levels, the new capital structure will be 50:50, the value of debt will be $5 million @ 8%, so the interest expense will be $0.4 million.
Amount in Millions
Operating Profit: $1
Less: interest expense 0.08
Profit before tax 0.92
Less tax @40% 0.368
PAT 0.552
Return on equity 11.04%
b) Amount in Millions
Operating Profit: $1
Less: interest expense 0.15
Profit before tax 0.85
Less tax @40% 0.34
PAT 0.51
Return on equity 10.2%
c) Amount in Millions
Operating Profit: $1
Less: interest expense 0.08
Profit before tax 0.92
Less tax 0.0
PAT 0.92
Return on equity 18.4%
In part (a) the return to equity shareholders is 11.04% whereas in part c it is 18.4%, this difference in return is due to non inclusion of tax in part c because of non profit organization.
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