can anyone answer these questions, for Understanding Healthcare Financial Management?

9/1/2014 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 1 Seattle Health Plans 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 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 cost 15 percent. c. Return to the initial 8 percent interest rate. Now, assume that EBIT can 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. 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 lessons about capital structure and risk does this illustration provide? d. Repeat the analysis for Part a., but now assume that Seattle Health Plans is a not-for-profit corporation and hence pays no taxes. Compare the results with those obtained in Part a. ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 2 Southern Healthcare and BestWell are for-profit HMOs that operate in Florida and Georgia. Currently, both are identical in every respect except that Southern is unleveraged while BestWell has $10 million of 5 percent bonds. Both HMOs report an EBIT of $2 million and pay corporate tax at a rate of 40 percent. The cost of equity to Southern is 10 percent. Assume that all of the MM assumptions hold. a. What total value would MM estimate for each HMO? b. What is the value of the equity of each HMO? c. What is the required rate of return on equity for each HMO? d. What is the corporate cost of capital for each HMO? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 3 Progressive Home Health Care Inc. is a for-profit provider of home health care services in the Pacific Northwest. At present, it has EBIT of $2 million per year, no debt, and a market value of approximately $12 million. Although management is pleased with the good financial condition of Progressive, they are also concerned that the firm might be the target of a potential hostile takeover by a large competitor. Therefore, Progressive is considering issuing debt to buy back shares, the interest on which would be tax deductible (its tax rate is 40 percent). Management recognizes that as the amount of debt increases, both the value of the firm and the risk of financial distress increase. The CFO estimates that the present value of any future financial distress costs is $8 million, and that the probability of distress increases with the amount of debt in the following steps: Probability of financial Value of debt distress 0 0% $2,500,000 1% $5,000,000 2% $7,500,000 4% $10,000,000 8% $12,500,000 16% $15,000,000 32% $20,000,000 64% a. What is Progressive's cost of equity and corporate cost of capital now? b. According to MM with corporate taxes, what is the optimal level of debt? c. According to MM with corporate taxes and financial distress, what is the optimal level of debt? d. Plot the value of Progressive, with and without the costs of financial distress, as a function of the amount of debt. Why do the lines differ in shape? ANSWER of the amount UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 4 Tar Heel Healthcare has no debt financing and has a firm value of $20 million. It has a corporate tax rate of 34 percent. The firm's investors are estimated to have marginal tax rates of 31 percent on interest income and 28 percent on stock income. The firm is planning to change its capital structure by issuing $10 million in debt and repurchasing $10 million of common stock. a. According to the MM view with corporate taxes, what is the value of the leveraged firm? b. According to the Miller view with corporate and personal taxes, what is the gain from leverage? UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 5 The Ensyder Nursing Home (ENH) is a zero growth firm with an EBIT of $250,000 and a corporate tax rate of 40 percent. ENH uses $1 million of debt financing, and the cost of equity of an unleveraged firm in the same risk class is 15 percent. The personal tax rates of ENH's investors are 30 percent on interest income and 20 percent (on average) on income from common stocks. a. What is the value of ENH according to MM with corporate taxes? b. What is ENH's value according to Miller (including personal taxes)? c. Suppose that the present value of financial distress costs is estimated to be $800,000, and that at a debt level of $1 million, ENH has a 20 percent probability of going bankrupt. What is the firm's value if these costs are added to the Miller model? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 6 International Health Associates (IHA) is just about to commence operations as an international health consulting firm. The firm will have book assets of $10 million, and it expects to earn a 16 percent return on these assets before taxes (EBIT = 16% x $10 million). However, because of certain tax arrangements with foreign governments, IHA will not pay any taxesthat is, its tax rate will be zero. Management is trying to decide how to raise the required $10 million. It is known that the required rate of return for an all-equity firm in this business is 11 percentthat is, R(Reu) = 11%. Further, IHA can borrow at a rate of R(Rd) = 6%. According to MM without taxes, what will be the value of IHA if it uses no debt? If it uses $6 million of 6 percent debt? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 7 Continue with the IHA example from Problem 6. Using VU from Problem 6, what are the values of the CCC and R(Re) at debt levels of D=$0, D=$6 million, and D=$10 million? What effect does leverage have on firm value? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 8 Continue with the IHA example from Problem 6. Assume the initial facts of the problem: R(Rd)=6%, EBIT=$1.6 million, R(Reu)=11%. Now assume that a 40 percent corporate tax rate exists. Find the new market values for IHA with zero debt and with $6 million of debt, using the MM with taxes formula. ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 9 Continue with the IHA example from Problem 6. Using VU from Problem 8, what are the values of the CCC and R(Re) at debt levels of D=$0, D=$6 million, and D=$10 million, assuming a 40 percent corporate tax rate? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 10 -- Capital Structure PROBLEM 10 Continue with the IHA example from Problem 6. Using data from Problem 9, plot the relationships between: - the debt ratio and the value of the firm - the debt ratio and the costs of capital (CCC, R(Re), and R(Rd)) ANSWER D $0 $6,000,000 $10,000,000 V D/V R(Re) R(Rd)(1-T) CCC