Question

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 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%
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.

Answer 1

The requested analysis could not be completed due to insufficient information. In general terms, introducing debt affects a firm's net income, total dollar return to investors, and ROE due to changes in interest expenses and tax savings. Varying interest rates and not-for-profit status further influence these outcomes, illustrating the relationship between capital structure and risk.

Step-by-step explanation:

The question relates to the impact of changing the capital structure on a firm's net income, total dollar return to investors, and return on equity (ROE). Specifically, it looks at how replacing half of Seattle Health Plans' equity with debt impacts these financial metrics under different scenarios: a fixed interest rate, a higher interest rate, varying operating incomes, and the case of operating as a not-for-profit.

Unfortunately, the provided information does not contain the necessary figures to perform the analysis requested by the student. However, in a general sense, if the company were to replace half of its equity with debt bearing an 8% interest rate, it would pay interest on this debt, reducing its taxable income and therefore taxes paid, potentially increasing after-tax income and ROE. On the other hand, a higher interest rate of 15% would lead to higher interest expenses and lower net income and ROE.

For the scenario with varying EBIT, the financial outcomes would be calculated for each level of operating income, and then expected values could be determined based on the probabilities provided. If Seattle Health Plans were not-for-profit and exempt from paying taxes, the impact of changing the capital structure would be different since tax savings from debt interest would be non-existent.