Primary Health Care is one of Australia’s leading listed healthcare companies. P

Question

Primary Health Care is one of Australia’s leading listed healthcare companies. Primary is a service company to medical and allied health professionals. A broad range of medical and related services are offered in Primary’s network of medical centres and pathology centres across Australia. Primary is also a leading provider of healthcare technology solutions to medical practitioners, medical practices and hospitals.

Primary’s market capitalisation currently runs at about $2,290.5 million, with a debt-to-equity ratio of approximately 1:3. The company’s CFO is currently recommending that the Board issue new debt worth 10% of the firm’s existing debt in order to repurchase shares for the same amount. He is advocating for a recapitalisation of the firm’s balance sheet in order to realise an increase in firm value by having a higher debt level. The debt issue will take the form of a 10- year corporate bond with a yearly coupon equal to the firm’s current cost of debt of 6.65%.

Primary’s CFO has approached Frontier Economics for assistance in formulating a solid argument for the proposed increase in financial leverage. While there is a tax advantage associated with debt financing, the team at Frontier Economics are concerned with the more subtle considerations about personal taxes at the investor level that also need to be taken into account. The consulting team will therefore consider three different tax settings:

• A world with no taxes

• A world with corporate taxes only

• A world with taxes paid on all levels

Primary’s marginal corporate tax rate is 30%. Assume that the marginal personal tax rate on income from debt is 35% and that the marginal personal tax rate on income from equity is 28%.

question:

Determine the present value of the interest tax shield for each of the three tax settings.

Explanation / Answer

Answer : Current Value of debt

= Market Value of primary * ( Debt / (Debt + Equity) )

= 2290.5 * (1/4)

= 572.625 MM

Value of new debt to be issued

= 10% of current debt

= 0.10 * 572.625

= 57.2625 MM

Calculation of tax sheilds

a) no taxes at any level

In case of no taxes at any level there will be no tax sheild due to interest on bonds

b) Corporate Taxes Only

Tax sheild = Interest expense * Corporate Tax rate

= 57262500 * 0.0665 *0.30

= 38079563*0.30

= 11,423,869d

c) taxes paid on all levels

in case of taxes at all levels the value of interest tax sheild would be as follows

T* = 1 - ((1-T of Corporate )(1- t of equity)/ ( 1- t of bond holders ))

= 1 - ((1-0.3)*(1-0.35)/(1-0.35))

= 1 - 0.7

= 0.3

Tax sheild = 38079562.5 * 0.3

= 11,423,869

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