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Chapter 13

- Seattle Health Plans currently use zero-dept 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.

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

- Redo the analysis but now assume that the debt financing would cost 15 percent

- Return to the initial 8 percent interest rate. Now assume the 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 EBIT and find the expected values of the firms not income, total dollar return to investor s and ROE. What lesson about capital structure and risk does this illustration provide?

- Repeat the analysis required for Part a but now assume that Settle Health Plans is a non-for-profit corporation and pays no taxes. Compare the result with those obtained in Part a.

- 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

- 0 percent

- 20 percent

- 40 percent

- St. Vincent Hospital has a target capital structure of 35 percent debt and 65 percent equity. Its cost of equity (fund capital) estimate is 13.5 percent and its cost of tax-exempt debt estimate is 7 percent. What is the hospital corporate cost of capital?

- Richmond Clinic has obtained the following estimate for its costs of debt and equity at various capital structure:

Percent 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 cost at alternative capital structure are not reliable in real world situations.