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 %.
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?
8.2
Calculate the after-tax cost of debt for the Wallace Clinic, a for-profit healthcare provider, assuming thatthe coupon rate set on its debt is 11 percent and its tax rate is
a. 0 percent
b. 20 percent
c. 40 percent
Assignment TIPS:
Consider using Excel to lay out the problem. First create a balance sheet with the following row descriptions and two columns - one for stock only and the other for stock/debt:
Total assets
Debt
Common stock
Total liabilities & equity
Remember that this is a balance sheet so total assets must equal total liabilities & equity.
Then, create an income statement (also with two columns) with the following row descriptions (see Slide 16 of chapter 8 PowerPoint presentation [Filename FHFCH08SSE2.ppt] available on this week's module):
Operating profit (we begin with this since the problem did not give a breakdown of income & expense)
Interest expense (for the first problem, this is 8%)
Taxable income (the net of earnings and interest)
Taxes (40%) (the amount of taxable income due for taxes)
Net income (the net of taxable income and taxes)
Total dollar return to investors (this is basically the net income)
Return on equity (ratio of dollar return to investors to equity in balance sheet, expressed as a percentage)