ABC health currently uses zero debt financing. Its operating profit is $2 millio

Question

ABC health currently uses zero debt financing. Its operating profit is $2 million and its tax rale is 30%. If it has $10 million in assets which are financed entirely by equity. Suppose the form is considering replacing half if its equity financing with debt financing that bears an interest rate of 10%. a. What is the impact of the new capital structure on the firm's profit, total dollar return to investors and the return on equity? Show both cases with all equity and financing and half equity financing. Consider the following net cash flows:

Explanation / Answer

Equity Debt at 10% EBIT 2000000 2000000 less interest 200000 EBT 2000000 1800000 less tax @30% 600000 540000 Net income 1400000 1260000 Equity 10000000 5000000 Return to investor in dollar 1400000 1260000 ROI Net Income/Equity 14.0% 25.2%

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