WHAT IMPACT WOULD THE NEW CAPITAL STRUCTURE HAVE ON THE FIRM’S NET INCOME, TOTAL DOLLAR RETURN TO INVESTORS, AND ROE?

WHAT IMPACT WOULD THE NEW CAPITAL STRUCTURE HAVE ON THE FIRM’S NET INCOME, TOTAL DOLLAR RETURN TO INVESTORS, AND ROE?

-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 with dept 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 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. Redo the analysis for each level of EBIT, and find the expected values for the firm’s income, total dollar return to investors, 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.
-Morningside Nursing Home, a not-for-profit corporation, Its tax exempt debt currently requires an interest rate of 6.2 percent and its target capital structure calls for 60 percent debt financing and 40 percent equity (fund Capital) financing. The estimated costs of equity for selected investors owned healthcare companies are given below:
Glaxo Wellcome 15.0%
Beverly Enterprises 16.4
HEALTHSOUTH 17.4


 

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