The board of directors of Hamilton health plan is considering the following alte

Question

The board of directors of Hamilton health plan is considering the following alternative financial structures: A. 30% debt 70% equity B. 40% debt 60% equity C. 50% debt 50% equity The cost of debt is expected to change between 1% and 5% over the range of percentages being considered. Stocks similar to Hamilton are returning dividends and growth yield rates of 10%. The return on high-grade commercial paper is currently 4% but is expected to increase over the next few years. Compute the cost of capital for the three alternatives. Which structure would you recommend to the directors and why? What additional information, if any, would you like to have before making your recommendation?

Explanation / Answer

We will use the formula of WACC = E% * Re + D%* (1-t) * Rd

where wacc = weighted average cost of capital

E% = % of equity, D% = % of debt, Re = Cost of equity, Rd = Cost of debt, t = tax rate

We will choose the method where cost of capital is the lowest. Re = 10% (Dividends and growth rates of stocks similar to hamilton). We assume tax rate as 30%. Rd will vary linearly with level of debt as per question increasing from 1% at 30% debt to 5% at 50% debt.

A. WACCa = 0.7*10% + 0.3*Rd*(1-0.3). For 1% = Rd, WACCa = 7.2 %

B. WACCb = 0.6*10% + 0.4*Rd*(1-0.3). For Rd = 3%, WACCb = 6.84%

C. WACCc = 0.5*10% + 0.5*Rd*(1-0.3). For Rd = 5%, WACCc = 6.75%

Cost of capital for the third alternative is the lowest and hence we will recommend the third alternative.

We will also like to evaluate potential distress cost of debt in the case we take a debt heavy structure. In 50% debt, we will need to see if Hamilton has the cash flows to service this level of debt. One way to check that is EBIT/Interest Expense. A high level indicates better ability to service debt. Also,since the return on high grade commercial paper is 4% and expected to increase, long term interest rates will increase as well so we need to balance tax shield benefit versus distress cost of debt (bankruptcy)

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