What impact would the new capital structure have on the firm’s net income, total dollar return to investors, and ROE?
What impact would the new capital structure have on the
firm’s net income, total dollar return to investors, and ROE?
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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 net income, total dollar return
toinvestors, 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.
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