Question 1: Seattle Health Plans currently uses zero debt financing. Its operating income (EBIT) is $1 million and it pays taxes at 40 percent rate. It has $5 million in assests 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 intial 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 the 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 firms net income total dollar return to investors aassume 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.
Question 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
Question 3:
St. Vincent's Hospital has a target capital structure of 35 percent debt and 65 percent equity. Its cist if equity (fund capital) estimate is 13.5 percent and its ost of tax exempt is 7 percent. What is the hospital corporate cost of capital?
Question 4:
Richmond Clinic has obtained the following estimates for its costs of debt and equity at various capital structures:
%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? Hint: Calculate its corporate cost of capital at each structure. Also note that data on component costs at alternative capital structuress are not reliable in real world situations.