# Understanding Health Care Financial Management - Excel

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```					            UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT

Chapter 10 -- Capital Structure Decisions

PROBLEM 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 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 of EBIT, and find the
expected values for the firm's net income, total dollar return to investors, and ROE. What lessons about
capital structure and risk does this illustration provide?
d. Repeat the analysis 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.

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT

Chapter 10 -- Capital Structure Decisions

PROBLEM 2
Southern Healthcare and BestWell are for-profit HMOs that operates in Florida and Georgia. Currently,
both are identical in every respect except that Southern is unleveraged while BestWell has \$10 million of
5 percent bonds. Both HMOs report an EBIT of \$2 million, pay corporate tax at a rate of 40 percent. The cost
of equity to Southern is 10 percent. Assume that all of the MM assumptions hold.
a. What total value would MM estimate for each HMO?
b. What is the value of the equity of each HMO?
c. What is the required rate of return on equity for each HMO?
d. What is the corporate cost of capital for each HMO?

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT

Chapter 10 -- Capital Structure Decisions

PROBLEM 3
Progressive Home Health Care Inc. is a for-profit provider of home healthcare services in the Pacific
northwest. At present, it has EBIT of \$2 million per year, no debt, and a market value of approximately
\$12 million. Although management is pleased with the good financial condition of Progressive, they are
also concerned that the firm might be the target of a potential hostile takeover by a large competitor.
Therefore, Progressive is considering issuing debt to buy back shares, the interest on which would be tax
deductible (its tax rate is 40 percent). Management recognizes that as the amount of debt increases, both
the value of the firm and the risk of financial distress increase. The CFO estimates that the present value
of any future financial distress costs is \$8 million, and that the probability of distress increases with the
amount of debt in the following steps:

Probability
of financial
Value of debt   distress
0              0%
\$2,500,000               1%
\$5,000,000               2%
\$7,500,000               4%
\$10,000,000               8%
\$12,500,000             16%
\$15,000,000             32%
\$20,000,000             64%

a. What is Progressive's cost of equity and corporate cost of capital now?
b. According to MM with corporate taxes, what is the optimal level of debt?
c. According to MM with corporate taxes and financial distress, what is the optimal level of debt?
d. Plot the value of Progressive, with and without the costs of financial distress, as a function of the amount
of debt. Why do the lines differ in shape?