Capital Structure Decision

Consider the following scenario:

XYZ Health Organization has a division that currently uses zero debt financing. Assume that the operating income (EBIT) is 1,000,000 SAR. Assume that the firm has 5,000,000 SAR in Assets with an equal amount in equity (because it currently has no debt). The firm wants to expand its product offerings and is considering replacing half of its equity financing with debt financing at an interest rate of 8%. The corporate tax rate is 20%. Assume that you are the Chief Financial Officer of the organization.

  1. Determine how the new capital structure would impact the firm’s net income, total dollar return to investors, and ROE?
  2. Conduct the analysis again but assume that the cost of debt has risen to 15%?
  3. Then using the original 8% interest rate, assume that annual EBIT has dropped to 500,000 SAR or could go as high as 1.5 million SAR (both with a probability of 20%). While there is a 60% chance that EBIT will remain 1,000,000 SAR. Redo the analysis for each level of EBIT and determine the expected values for the division’s net income, total dollar return to investors, and ROE.

After you have conducted all the calculations, make recommendations to the company as to which avenue the company should take. Consider what you have learned about the healthcare needs under SV2030 as well as your knowledge of the healthcare industry.

Discuss the considerations for risk and return for western investors who will be entering into Islamic financing arrangements. How will those investors consider the risk of this business endeavor?