Debt financing

Charity Hospital, established in 1895 as a non profit corporation, pays no taxes on income and receives no tax advantage for interest paid. The board of directors has approved expanded cancer treatment equipment that will require $10 million in debt capital to supplement $8 million in equity capital currently available. The $10 million can be borrowed at 7.5% per year through the Charity Hospital Corporation. Alternatively, 30-year trust bonds could be issued through the hospital’s for-profit outpatient corporation, Charity Outreach, Inc. The interest on the bonds is expected to be 9.75% per year, which is tax-deductible. The bonds will be sold at a 2.5% discount for rapid sale. The effective tax rate of Charity Outreach is 32%.

Which form of debt financing is less expensive after taxes?

 

Tri-States Gas Processors expects to borrow $800,000 for field engineering improvements. Two methods of debt financing are possible-borrow it all from a bank or issue debenture bonds. The company will pay an effective 8% compounded per year for 8 years to the bank. The principal on the loan will be reduced uniformly over the 8 years, with the remainder of each annual payment going toward interest. The bond issue will be 800 IO-year bonds of $1000 each that require a 6% per year interest payment.

(a) Which method of financing is cheaper after an effective tax rate of 40% is considered?

(b) What is the cheaper method using a before-tax analysis?

Solution:

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