13.1 (page,512)

Seattle Health Plans currently uses zero-debt financing. Its operating income (EBIT) is $1 million, and it pays taxes at a 40% 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 %.

A. What impact would the new capital structure have on the firms net income, total dollar return to investors, and ROE?

B. Redo the analysis, but now assume that the debt financing would cost 15% C. Return to the initial 8% interest rate. Now, assume that EBIT could be as low as $500,000 (with a probability of 20%) or as high as $1.5 million (with probability of 20%). There remains a 60% 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 corporation and pays no taxes. Compare the results with those obtained in Part a.

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Hint for Problem 13.1:

Here is a table with the data assuming a debt cost of 8 percent:

Balance Sheets

Stock Stock/Debt

Total assets $5,000,000 $5,000,000

Debt $ 0 $2,500,000

Common stock 5,000,000 2,500,000

Total liabilities & equity $5,000,000 $5,000,000

Income Statements

EBIT $1,000,000 $1,000,000

Interest expense 0 200,000(%8 of $2,5M)

Taxable income $1,000,000 $ 800,000

Taxes (40%) (400,000) (320,000)

Net income $ 600,000 $ 480,000

Total dollar return

to investors $ 600,000 $ 680,000($480K to owners+$200K to creditors as interest)

ROE ? ?

Where does the $80,000 extra return to investors(owners and creditors) come from?

Now, do the same calculation for %15 cost of debt financing