13.4 Is the Corporate cost of capital estimate based on historical or marginal cost?
The corporate cost of capital estimate is based on marginal costs because the purpose of
estimating a firm 's corporate cost of capital is to use the estimate
the marginal cost of capital,
the weighted average cost of new capital calculated by the marginal weight
marginal weight represents the proportion of various sources of funds to be employed in raising
Seattle Health Plans currently uses zero-debt financing. Its operating income (EBIT) 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 equity
financing with debt financing bearing an interest rate of 8 %.
A. What impact would the new capital structure have on the firm's net income, total dollar
returns to investors, and ROE?
B. Redo the analysis, but now assume that the debt financing would cost 15%
C. Return to the initial 8% interest rate. Now, assume that EBIT could be as low as $500,000
(with a probability of 20%) or as high as $1.5 million (with probability of 20%). There remains a
60% 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 returns 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 a not-for-
profit corporation and pays no taxes. Compare the results with those obtained in Part a. --Here is
a table with the data assuming a debt cost of 8 percent:
The new capital structure will be 50:50, with debt valued at $2,500,00 million at an 8
percent interest rate, resulting in interest expenses of $200,000.
Interest Expense (8% * 2,500,000)
= $ 200,000
Taxable Income (1,000,000 - 200,000)
Taxes (40%) (40% of 800,000)
= $ 320,000
Net Income (800,000-320,000)
Return On Equity = 0.48*40
Interest Expense (15% *2,500,000)
Taxable Income (1,000,000 - 375,000)
Taxes (40%) (40% * 625,000)