1) 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 financing with debt 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 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 net income, total dollar return to investors, and 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 not for-profit corporation and pays no taxes. Compare the results with those obtained in Part a.
2) Morningside Nursing Home, a not-for-profit corporation, is estimating its corporate cost of capital. Its tax-exempt debt currently requires an interest rate of 6.2 percent, and its target capital structure class for 60 percent debt financing and 40 percent equity (fund capital) financing. The estimated costs of equity for selected investor-owned healthcare companies are as follows;
GlaxoSmithKline 15.0%
Long-Term Care Corporation 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?
3) Better Health, Inc., is evaluating two investment projects, each of which requires an up-front expenditure of $1.5 million. The projects are expected to produce the following net cash inflows:
Year ProjectA Project B
1 $ 500,000 $2,000,000
2 1,000,000 1,000,000
3 2,000,000 600,000
a.) What is each project's IRR
b.) What is each project's NPV if the cost of capital is 10 percent? 5 percent? 15 percent?
4) Capitol Healthplans Inc., is evaluating two different methods for providing home health services to its members. Both methods involve contracting out for services, and the health outcomes and revenues are not affected by the method chosen. Therefore, the incremental cash flows for the decision are all outflows. Here are the projected flows:
Year Method A Method B
0 ($300,000) ($120,000)
1 (66,000) (96,000)
2 (66,000) (96,000)
3 (66,000) (96,000)
4 (66,000) (96,000)
5 (66,000) (96,000)
a. What is each alternative's IRR?
b. If the cost of capital for both methods is 9 percent, which method should be chosen? Why?
5) The staff of Jefferson Memorial Hospital has estimated the following net cash flows for a satellite food services operation that it may open in its outpatient clinic:
Year Expected Net Cash Flow
0 ($100,000)
1 30,000
2 30,000
3 30,000
4 30,000
5 30,000
5 (salvage value) 20,000
The Year 0 cash flow is the investment cost of the new food service, while the final amount is the terminal cash flow. (The clinic is expected to move to a new building I five years.) All other flows represent net operating cash flows. Jefferson's corporate cost of capital is 10 percent.
a.) What is the project's IRR? It's MIRR?
b.) Assuming the project has average risk, what is its NPV?
c.) Now, assume that the operating cash flows in years 1 through 5 could be as low as $20,000 or as high as $40,000. Furthermore, the salvage value cash flow at the end of year 5 could be as low as $0 or as high as $30,000. What are the worst-case and best case IRR's? The worst-case and best-case NPV's?