Southland Hospital is considering a new venture that will allow it to reach pati

Question

Southland Hospital is considering a new venture that will allow it to reach patients with endocrine conditions using mobile phones and the internet. The venture will require a $8 million investment in technology and equipment. Southland Hospital can use retained earnings (equity) solely, or issue debt for 40 percent of the expenditures, at an annual interest rate of 6 percent. Operating income before taxes is forecast at $1.75 million, and Southland faces a 34 percent marginal corporate income tax rate.

A) What would Southland’s net income be if it only used equity? $  

B) What would Southland's total dollar return to investors be if it only used equity? $  

C) What would Southland's return on equity be if it only used equity?  %

D) What would Southland’s net income be if it used 40 percent debt financing? $  

E) What would Southland’s total dollar return to investors be if it used 40 percent debt financing? $

Explanation / Answer

Net operating income = 1750000

If only equity, debt = 0, interest = 0, equity = total investment = 8000000

A. net income = (Operating income - interest)(1- tax rate) = 1750000(1-0.34) = 1155000

B. The net income will be the dollar return to investors = 1155000

C. ROE = net income/ owner's equity = 1155000/8000000 = 0.1443 = 14.43%

If 40% debt: debt = 40% of investment = 0.40*8000000 = 3200000, interest = 0.06*3200000 = 192000, equity = investment - debt = 8000000-3200000 = 4800000

D. net income = (Operating income - interest)(1- tax rate) = (1750000-192000)(1-0.34) = 1028280

E. The net income will be the dollar return to investors = 1028280

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