CASE STUDY: Capital Structure II Primary Health Care Limited Primary Health Care
ID: 1194105 • Letter: C
Question
CASE STUDY: Capital Structure II Primary Health Care Limited
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%.
Required:
On behalf of Frontier Economics, prepare a presentation and written brief for the board of directors of Primary Health Care, addressing the following requirements:
1. Calculate the effective tax advantage of using debt.
2. Determine the present value of the interest tax shield for each of the three tax settings.
a. Draw a timeline with the years from 1 to 10.
b. Calculate the interest payment on the bonds for each year.
c. Calculate the interest tax shield in each of the three tax settings.
d. Calculate the present value of the interest tax shield in each of the three tax settings.
3. Determine the new share price and number of shares outstanding in each of the three tax settings.
a. Assume that the current market value of Primary’s equity is based on a current share price of $4.50 and total shares outstanding of 509,000,000.
b. Determine the new market value of equity if the share repurchase occurs.
c. Determine the share price at which shareholders are willing to sell their shares given the information about the new debt. Note: Format the share price with three or four decimals, as the differences in share price might be less than one cent.
d. Determine the number of shares outstanding after the repurchase.
4. The CFO of Primary is considering suggesting even a doubling (i.e. 100% instead of 10% increase) of debt in order to maximise the share price. Provide an explanation of the critical assumptions made within the analysis above, and discuss the limits of generating tax benefits.
Explanation / Answer
Asset transformation by an FI involves purchasing primary assets and issuing secondary assets as a source of funds. The primary securities purchased by the FI often have maturity and liquidity characteristics that are different from the secondary securities issued by the FI. For example, a bank buys medium- to long-term bonds and makes medium-term loans with funds raised by issuing short-term deposits.
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