Question

Seattle Health Plans currently uses zero-debt financing. Its operating profit is $6 million, and it pays taxes at a 23 percent rate. It has $10 million in assets and, because it is all-equity financed, $10 million in equity. Suppose the firm is considering replacing 59 percent of its equity financing with debt financing that bears an interest rate of 9 percent. What impact would the new capital structure have on the firm's ROE (return on equity)

Answer 1

Answer: ROE increases by 56.5% to 102.7%

Explanation:

ROE before capital structure change:

= Net income / Equity

= (Operating income * ( 1 - tax)) / Equity

= (6,000,000 * (1 - 23%)) / 10,000,000

= 46.2%

With new capital structure:

Debt financing = 59% * 10,000,000

= $5,900,000

Interest = 9% * 5,900,000

= $531,000

Net income = (Operating profit - interest) * ( 1 - tax)

= (6,000,000 - 531,000) * ( 1 - 23%)

= $‭4,211,130‬

Return on Equity = ‭4,211,130‬ / ( 10,000,000 - 5,900,000)

= 102.7%

Difference:

= 102.7 - 46.2

= 56.5%