-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 with dept 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.
-Morningside Nursing
Home, a not-for-profit corporation, Its tax
exempt debt currently requires an interest rate of 6.2 percent and its target
capital structure calls for 60 percent debt financing and 40 percent equity
(fund Capital) financing. The estimated costs of equity for selected investors
owned healthcare companies are given below:
Glaxo Wellcome 15.0%
Beverly Enterprises 16.4
HEALTHSOUTH 17.4
Humana 18.8
Glaxo Wellcome 15.0%
Beverly Enterprises 16.4
HEALTHSOUTH 17.4
Humana 18.8
a.
What is the best
estimate for Morningside’s cost of equity?
b.
What is the firm’s
corporate cost of capital?
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