Southwest Physician, a medical group practice in Oklahoma City, is just being fo

Question

Southwest Physician, a medical group practice in Oklahoma City, is just being formed. It will need $2 million of total assets to generate $3 million in revenues. Furthermore, the group expects to have a total margin of 5 percent. The group is considering two financing alternatives. First, it can use all equity financing by requiring each physician to contribute his or her pro rate share. Second, the practice can finance up to 5o percent of its assets with a bank loan. Assuming that the debt alternative has no impact on the expected total margin, what is the difference between the expected return on equity (ROE) if the group finances with 50 percent debt versus the expected ROE if it finances entirely with equity capital?

Explanation / Answer

ROE = Profit margin x Total asset turnoverxEquity multiplier ======================================================================================================================== Profit margin = 5% ======================================================================================================================== Total asset turnover ratio = Sales / Assets = $3,000,000 / $2,000,000 = 1.5 times ======================================================================================================================== ROE = 0.05 * 1.5 * 1= 0.075 or 7.5% ======================================================================================================================== Therefore, the ROE when the firm uses all equity is 7.5% ======================================================================================================================== Equity multiplier = 1 + (Debt-equity ratio) = 1 + (Total debt / Total equity) = 1 + (0.50 / $0.5)= 1 + 1 = 2 ======================================================================================================================== ROE = 0.05 * 1.5 * 2 = 0.15or 15% ANSWER ========================================================================================================================

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