Your firm, General Hospital currently uses zero debt financing. Its operating in

Question

Your firm, General Hospital currently uses zero debt financing. Its operating income (EBIT) 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 bearing an interest rate of 8.5 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 be 15 percent.

c. Return to the initial 8 percent interest rate. Now assume the 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 $1 million. Rework the numbers for each level of

EBIT and find the expected values for the firm’s net income, total dollar return to investors and

ROE. What is the lesson about capital structure and risk provided in this illustration?

Explanation / Answer

a. With the new capital structure, the interest cost = 0.085*2.5 = 212,500

EBT = EBIT - Interest cost = 1 million - 212,500 = 787,500

EAT = 0.6*787,500 = 472,500

ROE = 472,500/2,500,000 = 0.189 or 18.9%

b. Debt financing at 15%

Interest cost = 2,500,000 * 0.15 = 375,000

EBT = 1,000,000 - 375,000 = 625,000

EAT = 0.6*625,000 = 375,000

ROE = 375,000/2,500,000 = 0.15 or 15%

c. Interest rate = 8%

EBIT(A) = 500,000 => EBT = 500,000 - 2,500,000*0.08 = 300,000 and EAT = 0.6*300,000 = 180,000

EBIT(B) = 1,500,000 => EBT = 1,500,000 - 2,500,000*0.08 = 1,300,000 and EAT = 780,000

EBIT(C) = 1,000,000 => EBT = 1,000,000 - 2,500,000*0.08 = 800,000 and EAT = 480,000

Expected value of EAT = 0.2*180,000 + 0.2*780,000 + 0.6*480,000 = 36,000 + 156,000 + 288,000 = $480,000

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