13.1 Seattle health plans currently uses zero debt financing. Its operating profit 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 that bears an interest rate of 8%.
a) What impact would the new capital structure have on the firm’s profit, total dollar return to investors, and return on equity?
b) Redo the analysis, but now assume that the debt financing would cost 15%.
c) Repeat the analysis required for Part a, but now assume that seattle health plans is a not for profit corporation and hence pays no taxes. Compare the results with those obtained in part a.
Answer:
a) With 50% debt levels, the new capital structure will be 50:50, the value of debt will be $5 million @ 8%, so the interest expense will be $0.4 million.
Amount in Millions

Operating Profit: $1

Less: interest expense 0.08

Profit before tax 0.92

Less tax @40% 0.368

PAT 0.552
Return on equity 11.04%
b) Amount in Millions
Operating Profit: $1

Less: interest expense 0.15

Profit before tax 0.85

Less tax @40% 0.34

PAT 0.51
Return on equity 10.2%
c) Amount in Millions
Operating Profit: $1

Less: interest expense 0.08

Profit before tax 0.92

Less tax 0.0

PAT 0.92
Return on equity 18.4%
In part (a) the return to equity shareholders is 11.04% whereas in part c it is 18.4%, this difference in return is due to non inclusion of tax in part c because of non profit organization.

• 13.2 Before tax Cost of Debt = 11%
(a) 0% Tax rate
After-tax Cost of Debt = 11% (1 - 0%)
After-tax Cost of Debt = 11%
(b) 20% Tax rate
After-tax Cost of Debt = 11% (1-0.20)
After-tax Cost of Debt = 0.11 (0.80)
After-tax Cost of Debt = 0.088 (or) 8.80%
(c) 40% Tax rate
After-tax Cost of Debt =