Problems

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 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.

2 Calculate the after-tax cost of debt for the Wallace clinic, a for-profit healthcare provider, assuming that the coupon rate set on its debt is 11 percent and its tax rate is:

a. 0 percent
b. 20 percent
c. 40 percent

3 St. Vincent's Hospital has a target capital structure of 35 percent debt and 65 percent equity. Its cost of equity (fund capital) estimate is 13.5 percent and its cost of tax-exempt debt estimate is 7 percent. What is the hospital's corporate cost of capital?

4 Richmond Clinic has obtained the following estimates for its costs of debt and equity at various capital structures:

Percent Debt After-Tax Cost of Debt Cost of Equity
0% _ 16%
20 6.6% 17
40 7.8 19
60 10.2 22
80 14.0 27

What is the firm's optimal capital structure?