Consider The Following Scenario: XYZ Health Organization ✓ Solved

Consider The Following Scenarioxyz Health Organization Has A Division

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. Determine how the new capital structure would impact the firm’s net income, total dollar return to investors, and ROE? Conduct the analysis again but assume that the cost of debt has risen to 15%? 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?

Sample Paper For Above instruction

Introduction

This analysis explores the implications of leveraging debt in the capital structure of XYZ Health Organization's division, considering various interest rates, operational income levels, and the broader context of healthcare financing and investment risks. Understanding how financial decisions impact net income, return to investors, and return on equity (ROE) is vital for strategic planning, especially under the evolving landscape of healthcare provision aligned with SV2030 goals and Islamic finance principles.

Background and Context

XYZ Health Organization operates a division with an asset base of SAR 5,000,000, entirely equity-financed initially. Its current EBIT of SAR 1,000,000 indicates robust operational performance. The organization's strategic plan involves replacing 50% of equity with debt to fund expansion, with interest rates considered at 8% and 15%. The corporate tax rate affects net income calculations and investor returns. These capital structure changes are contextualized within the broader healthcare industry, which emphasizes sustainable growth, cost-effectiveness, and alignment with national healthcare strategies under SV2030.

Impact of Changing Debt Levels and Interest Rates

Scenario 1: Debt at 8%

When considering the initial scenario with 8% debt interest, we analyze the effects on net income, total return, and ROE. The introduction of debt provides tax shields, potentially increasing after-tax profits and investor returns. The calculations show an increasing effect on ROE as debt levels rise, due to leveraging benefits, but also introduce higher financial risk.

Scenario 2: Debt at 15%

At a higher debt interest rate of 15%, the benefits of leverage diminish as higher interest expenses offset tax shields, possibly reducing net income and ROE. The increased cost of debt amplifies financial risk, particularly if EBIT declines, emphasizing the importance of careful debt management.

Analysis at Different EBIT Levels

Calculations for each scenario involve deducting interest expenses, applying taxes, and determining the net income and return metrics. Using probability distributions, expected values are derived, providing insights into the potential financial outcomes and risks associated with varying operational performances.

Strategic Recommendations

Based on the analysis, the organization should consider the optimal debt level balancing leverage benefits against financial risk, especially considering industry-specific uncertainties, healthcare needs under SV2030, and Islamic finance constraints. The analysis underscores that moderate gearing with sustainable debt costs could maximize shareholder value while maintaining financial stability.

Considerations for Western Investors and Islamic Financing

Western investors entering Islamic financing arrangements analyze risks differently due to the prohibition of interest (riba) and emphasis on ethical investing. Risk considerations include credit risk, Shariah compliance, and the macroeconomic stability of healthcare investments in the context of Saudi Vision 2030. Investors assess the business's risk profile through due diligence on project sustainability, profit-sharing mechanisms, and the risk-sharing principles fundamental to Islamic finance, which could mitigate some risks associated with conventional debt but introduce others related to compliance and profit distribution.

Conclusion

Ultimately, the decision to leverage debt must align with the organization's strategic objectives, industry conditions, and investor expectations. A balanced approach that considers risk, return, and compliance with Islamic finance principles will optimize financial performance and support healthcare development under SV2030.

References

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