Homework SourseTexas health plans currently use zerodebt financing Its oper
Texas health plans currently use zero-debt financing. Its operating income (earnings before interest & taxes or EBIT) is $1 million, it pays taxes at 40% rate. It has $5 million in assests & because all its equity is financede, $5 million in equity. Suppose the firm is considering replacing half of its equity financing with debt financing bearing an interst 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 asume that the debt financing would cost 15%?
(c) return to the initial 8% interst rate. Now assume that EBIT could be as low as $500,000 (with 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, & find the expected values for the firm\'s net income, total dollar return to investors & ROE. What lession about capital structure and risk does this illistration provide?
Solution
a)
All Equity 50% Debt
Balance Sheets:
Current assets $5,000,000 $5,000,000
Fixed assets $ 0 $ 0
Total assets $5,000,000 $5,000,000
Bank loan (8% Cost) $ 0 $2,500,000
Common stock $5,000,000 $2,500,000
Total liabilities and equity $5,000,000 $5,000,000
Income Statements:
Revenues $6,000,000 $6,000,000
Operating costs $5,000,000 $5,000,000
Operating income $1,000,000 $1,000,000
Interest expense $ 0 $ 200,000
Taxable income $1,000,000 $800,000
Taxes (40%) $ 400,000 $320,000
Net income $ 600,000 $480,000
ROE 12 % (600,000/5,000,000) p.449 19.2%
Total dollar return to investors $600,000 $680,000
b)
All Equity 50% Debt
Balance Sheets:
Current assets $5,000,000 $5,000,000
Fixed assets $ 0 $ 0
Total assets $5,000,000 $5,000,000
Bank loan (15% Cost) $ 0 $2,500,000
Common stock $5,000,000 $2,500,000
Total liabilities and equity $5,000,000 $5,000,000
Income Statements:
Revenues $6,000,000 $6,000,000
Operating costs $5,000,000 $5,000,000
Operating income $1,000,000 $1,000,000
Interest expense $ 0 $ 375,000
Taxable income $1,000,000 $ 625,000
Taxes (40%) $ 400,000 $ 250,000
Net income $ 600,000 $ 750,000
ROE 12 % (600,000/5,000,000) p.449 15%
Total dollar return to investors $600,000 $ 750,000
c)
EBIT $500,000 EBIT $1.5 mill All Equity
Balance Sheets
Current assets $5,000,000 $5,000,000 $5,000,000
Fixed assets $ 0 $ 0 $ 0
Total assets $5,000,000 $5,000,000 $5,000,000
Bank loan (8% Cost) $ 0 $2,500,000 $ 0
Common stock $5,000,000 $2,500,000 $5,000,000
Total liabilities and equity $5,000,000 $5,000,000 $5,000,000
Income Statements:
Revenues $5,500,000 $6,500,000 $6,000,000
Operating costs $5,000,000 $5,000,000 $5,000,000
Operating income $ 500,000 $1,500,000 $1,000,000
Interest expense $ 0 $ 0 $ 0
Taxable income $ 500,000 $1,500,000 $1,000,000
Taxes (40%) $ 200,000 $ 600,000 $ 400,000
Net income $ 300,000 $900,000 $ 600,000
ROE 6 % (600,000/5,000,000) 18% 12%
Total dollar return to investors $300,000 $900,000 $ 600,000
Lession:-
When debt is utilized the operating income will be higher leading to higher ROE.
