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, which is the weighted average cost of new capital calculated by the marginal weight . The marginal weight represents the proportion of various sources of funds to be employed in raising additional funds. Problem 13.1 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: a. 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. EBIT = $1,000,000 Interest Expense (8% * 2,500,000) = $ 200,000 Taxable Income (1,000,000 - 200,000) =$800,000 Taxes (40%) (40% of 800,000) = $ 320,000 Net Income (800,000-320,000) =$ 480,000 Return On Equity = 0.48*40 = 19.20% b. EBIT =$1,000,000 Interest Expense (15% *2,500,000) =$375,000 Taxable Income (1,000,000 - 375,000) =$625,000 Taxes (40%) (40% * 625,000) =$ 250,000
Net Income (625,000-250,000) =$375,000 Return on Equity = 0.375*40 = 15% c. EBIT = $600,000 Interest Expense (8%* 2,500,000) =$200,000 Taxable Income (600,000 - 200,000) =$400,000 Taxes (40%) (40% * 400,000) =160,000 Net Income (400,000 - 160,000) =$240,000 Return on Equity = 0.240 * 40 =9.6 d. if the company does not need to pay taxes, then, it does not need to worry about capital structure. In the case of all-equity financing, the ROE would be higher. The extra $80,000 ($200,000 x 40%) has been emerged due to tax-shield on the interest expense of $200,000
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