Seattle Health Plans currently use 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 equality 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 for part a, but not assume that Seattle Health Plan is a not-for- profit and hence pays no taxes. Compare the results with those obtained in part a.