case 17 in gapenski cases in health care finance

SOUTHEASTERN HOMECARE COST OF CAPITAL 17 SOUTIBASTERN HOMECARE WAS founded m 1992 in Miama, Florida, au a satale partnership by Mana Gosales, MD, Ramon Garcia RN, and Ron Spacks, LPT. Its purpose is to peoside as a-home ahernative to hospitals and ambulatory care facilities for besic heelthcane services provided by physacians, registered natves, licmsed peactical surses, and physacal therapats (Foe more infoomation on home health services, see the websute of the National Association for Home Cae& Hosice at wwwnabc.o) Southeasters enjoyed esormous success froem the fist day of operations Even s funders were surpaed ast how eagy it was to establiab and run the bosimess Its founding coincided with the seerch by thard-paty payers foe altermative and poseshially less costly delirvery settiegs Because of its success in mesopolutan Mas Southeasters expanded services into Fort Lauderdale and West Pim Beach and then moved no othes metcopolatan areas in Florida and ac the U'S Souhrast Sostheasters aho expanded services at each location to snclude ocupatsional, speech, and rehabilitation therapies ne founders bad sut etal personal resources to start outheastem and they had enough confidence-ther bustness plan to commit mos of their own funds 1o the new venture However, afar umiy six yean. the external capital roquarements beought ot by rapid growth exhaustede fou des personal tinds. forrag them to banor leasih. Som a hough they still needed external cagetal to fiance growth, thes ability to boerow an ressonable rahes was exhusted Thus, it 2002 the foundere incorpoested Sowheesters asd, in 2005, sold commoes stock to the poblic through an mitial publi oftering. Todry, the fouoders still retais a large bat misosity ounernlop postio Southeasterm is widely recomized as one of the regional leades in the home heal care maustry In 2012, won an anrard for beine one of the 100 bestmanaged small companies in the Ueited Stanes It has two aperaline diviota Healthcaze Services and Infcemathon Systems The Heahthcare Services division operates the home health care senices dt all 22 locehoa Becesuse salea and cetngs im ais dinson aue selatively predicteble, the basiness risk of this devisson is abost average The lnfornation Systess divisios tns the computer sodhw are thar Southeastern desigsed to coestrol ats an opzationi and sells to other home health care comparan Tas sotware megrate"-vetery control nsit scheduling, chmeal record keeprze, billtag and coflections and payroll ito a single package Athough the software is exceest, it comgpetes head-to-bead wiah sevceal nagjor sofwase finmas well as uith other u_fermation wysem semres and inforttialot tanagement conainte tii Because oftascorertatson and s i The d Keys to it to ether home bealth care companues This software integrates ory collectioe, and payroll i firms as well as with other infomation system services and in the rapid teehmological changrs in the infoemation services business risk than does the Healtheane Services dinvsision control, visit schedaling, chinical secordkeeping, billng and into a single package. Although the sotware is excellent, it competes bead-to-hrad with several major sofrware ormatice management consuhing finns. Because of this competition and field, Southeasterm considers the Inforesation Systemsa davision to carry more Arhoueh its gmoeth bas bem exceptional Southrastern developod on a more ranfom thas plannced basih The foumders simpl decaded foe a new facility, tan an advertisement in a local neuspaper to het climical professionals and support staff, ant an exponenced manage hom an established afface to the new locatain, and began to make money aktaal in maalv Formal decison structures were almost monexistent, bur Southeasbern's head start and bnight, energetic founders easily overcame any deficiencies in Hawever, recent changes in the market for home health care services portend a more difficut envomment in the firtare. First, relatively generous paymment amousts in the 1990s and most of the 2000s produced istese cospetition in he home health care industry Other investor owned home bealth care agencies sprung up quickly, especially in majoe citirs, and several hospitals is Soudhrastes's service area, includinig not-for-profits, began to offer home health care services. Secoed, the rapid inczease in home care expenditures prompted pryers to drastically reduce reimbursement amounts jast as new capacity merand In particulxr, the Centers for Medicare & Medicaid Services has reduced payment rates made under the home health prospectne pe yment system for several year n are w Because of these dan es, southeastern's board of directors concluded diat de conpany murt topphr state-of-the-arT techniques in both its operations and its corporate anagerial procexs. As a Enst strp, the board directed the financial vice presedent (VP) to develop estimate for Southeasterna cost ufcaptal The financtal VP in turn, detted Soute titem's treanert Clark Ruffin to prepare and submit a cost-of-capital estiemate in two weeks He has an accounting backound, and his primary task soince taking over as treasueer has been cash and shoet-term liability managmest is, he is scmewhat apprebetsive abouat his sew agc heightened by the fact that one board member is a well-egaded Uain eity of Florsda fisance profece an apprchemsion thuet Clack began by seviewing Southeasteen's 2017 financial statements (peesentrd in gsbit 121 n smplified form) and by obtairing some selected market data (presented in exhibit 12 Nest, he mscmbled the followeg data s 11 2017 Financial Statoment Cash and marketable securities Accounts recevable 26 10 Extracts Notos paysble 02 in Millions of Dolars) Curent labilties 2 9029.1 @oegg Gapen." x Net foxed assets 41.9 Long-term debt Common stock Total liabilties 20.0 29.3 $51.6 Total assets $516 Income Statement Net revenues Cash expenses Depreciatiorn $80.6 71.8 2.8 s 6.0 2.4 3.6 1.8 1.8 Taxable income Taxes Net incorme Dividonds Additions to retained eamings EXHIBIT 172 Expacted Rate of Raturnm on the Marker Selected Market Data Expected fate of return on the S&P 500 Index-11.0% Required Rate of Raturn on Long-Term Debt of an Average Company Yield to maturity on A ated long-term debt for a company with a beta of 10-70% Curront Yiald Curve on US Treasury Secunithios arm to yiaid 3 months 2.5% . 25% 3.0 6 months 9 months 5 yoars 10 yoers 15 yegrs 20 yowrs 26 yoors 0 years 3.5 4.0 4.5 4.8 5.0 5.1 5.2 Long Term Debt theasten's long-term dete cst of 7.5 percint coupen, BBB-cated veniansual pasmene bonds with 15 yeas cemairing to maturity The bonds recently traded at a peice of 5956 11 per $1,000 par valse bond The bosds re caluble in five yeas at pa vabue plus & call permum of Ss0 for a total of $1.050 - The founders have an aversion to short-tem dete, so such Gebt is uied orily to fiand cyclical working copital needs. Sostsoste' financial plas calls for the asue of 30-year boade to meet long term debe nds Equity Southeastem's last dividend (DO) was 50.17, and its common mock now sells at a prce of 55.25 per share. The compony bon 20 mallion common sharex stodig In the past few years, Southeasters fas a raod a 20 percn an equty and bas paid out aboust 50 percest ofita nct incon as droidends Souheastems hissorical beta, as mcmurod by sereral asalyss uto follow the stock, falls to the rge of 1 3 to 15 Southrasters's hestorncal beta, as measured by several analysts who follow the stock falls in the range of 13 to 1.5 Capital Structure Southrastem's federal plas-state tax ate is 40 percent Southeastern's target capital structure mclodes weighes of 35 percent long-tem debe asd 65 percent common stock Operating Divisions Ahout 60 pencent of Southeastem's operating assets are used by the Healthcare Services division, and 40 percest by the Informatson Systems divission Masapement's best estimate of the Healtheare Services divoon's beta 10 Following are the two decasions wwwestment opportubes for next year Healthcare Senvaces De A ew office n Naples A r office S 9.3% Expanded ballngo Clark has luted you as a consultant to develop Southeestem's averall coeporate cost of capital. You wall have to meet with the finaacial nd the finence peofessoc-to present you addess several concems ratsed at the last board seetung about the cout-of- dhuat the corporate cost-of-capital estimuate is indluenced by several Eactoes, sonse of which are VP-ed possibly with the peesidens and the full board of durectors (including the founders a findmes and anowes any question capital estmate Fust, the board chair soted corporate c estrmal to de usiness She s petcularly interested an the a ls addinon to performing a standard anahsas, you must a mpact on the estimated corpocate cost of capital of factors hat cannor be acros the commpnyrgardless of as Second the r dnisonal presadests questioned wty a single cost of capital will be applied aczou the company dinsssonal nsk differesces C Clark has asked you to addeess thas question by developing drvisional costs of capital Thrd the founders alerted the group to dar thueat posed by home health care bssinesses atarted by not foe-profit hosperals, whach have oth com the sense that they do not pay diridends) and tax adv antages To help assess this threat, Clark has aked you to emmane the cost of capital Sor n aessge not-for-profit bospitals hosse Sealth case business, statine wath the snformation n esh Indomution Systems Dviso A new healthcare encord Expnded biling sodtware system 12.2% 13.2% Clark has hirrd you as a consultant to develop Southeasterm's overall corporate cast of capital. You will have to meet with the fiuscial findings and awwer any questions VP-and possibly with the pressdent and the fall board of darectors (including the founders and the finance professor) -to peesemt your capital nstimate Fust, the board chair strd tat the coepente caal-ofaptul estmae inflened by Xial frtors, sate of ulica are extermal to the business. She is particslarty unterested in the umpact on the estimatod corpoeatr cot of capital of factors that cannot be nfluenced by manageial actions divissonal risk differences. Clark has anked you to address ths question hy developing dinisonal costs of capital cont of capital foe an anverage sot-for profit haepinal's home health care busnes Second, the divisional presidemts questioned why a single cost of capital will be applied across the compaxy, segardless of any Thard, the fornders alested the group to the deeat posed by home bealth care bsinea started by not for-peofit bospitals, which have the sense that they do not pey drvidends) and tax advanmares To help asess thais threat Clark has asked you ta estimate te , stoaerting with the informathos in sshibst 173 Tarm Ccital Stucs Selected Not-for-Profit 30 parcent dabt Hospital Data rnt equity Inst assets Avarage Cost of Deer Interest ratean arated taroempr borde-50% at CASE SOUTHEASTERN HOMECARE COST OF CAPITAL SOUTHEASTERN HOMECARE WAS founded in 1992 in Miami, Florida, as a taxable partnership by Maria Gonzalez, MD; Ramon Garcia, RN; and Ron Sparks, LPT. lts purpose is to provide an at-home alternative to hospitals and ambulatory care facilities for basic healthcare services provided by physicians, registered nurses, licensed practical nurses, and physical therapists. (For more information on home health services Pg. 80 105 Reader Contents Notebook Bookmarks 0.05K/s O08:29 more information on home health services, see the website of the National Association for Home Care & Hospice at www.nahc.org.) Southeastern enjoyed enormous success from the first day of operations. Even its founders were surprised at how easy it was to establish and run the business. Its founding coincided with the search by third- party payers for alternative and potentially less costly delivery settings. Because of its success in metropolitan Miami, Southeastern expanded services into Fort Lauderdale and West Palm Beach and then moved into other metropolitan areas in Florida and across the US Southeast. Southeastern also expanded services at each location to include occupational, speech, and rehabilitation therapies The founders had sufficient personal resources to start Southeastern, and they had enough confidence in their business plan to commit most of their own funds to the new Pg. 80 105 Reader Contents Notebook Bookmarks 0.7K/sO08:29 commit most of their own funds to the new venture. However, after only six years, the external capital requirements brought on by rapid growth exhausted the founders' personal funds, forcing them to borrow heavily. Soon, although they still needed external capital to finance growth, their ability to borrow at reasonable rates was exhausted Thus, in 2002, the founders incorporated Southeastern and, in 2005, sold commorn stock to the public through an initial public offering. Today, the founders stil retain a large but minority ownership position at Southeastern, and the Southeastern stock trades in the over-the-counter market Southeastern is widely recognized as one of the regional leaders in the home health care industry. In 2012, it won an award for being one of the 100 best-managed small companies in the United States. It has two operating divisions: Healthcare Services and Information Systems. The Healthcare Pg. 80 105 Reader Contents Notebook Bookmarks 0.14K/s O 08:30 nformation Systems Services division operates the home health care services atall22 locations. Because sales and earnings in this division are relatively predictable, the business risk of this division is about average. ealthcare The Information Systems division maintains the computer software that Southeastern designed to control its own operations and sells it to other home health care companies. This software integrates inventory control, visit scheduling, clinical record keeping, billing and collections, and payroll into a single package. Although the software is excellent, it competes head-to- head with several major software firms as well as with other information system services and information management consulting firms. Because of this competition and the rapid technological changes in the information services field, Southeastern considers the Information Systems division Pg. 80 106 Reader Contents Notebook Bookmarks 0.08K/s O 08:30 to carry more business risk than does the Healthcare Services division. Although its growth has been exceptional, Southeastern developed on a more random than planned basis. The founders simply decided on a location for a new facility, ran an advertisement in a local newspaper to hire clinical professionals and support staff, sent an experienced manager from an established office to the new location, and began to make money almost immediately. Formal decision structures were almost nonexistent, but Southeastern's head start and bright, energetic founders easily overcame any deficiencies in managerial decision-making processes However, recent changes in the market for home health care services portend a more difficult environment in the future. First, relatively generous payment amounts in the 1990s and most of the 2000s produced Pg. 80 106 Reader Contents Notebook Bookmarks 0.89K/s O 08:30 intense competition in the home health care industry. Other investor-owned home health care agencies sprung up quickly, especially in major cities, and several hospitals in Southeastern's service area, including not-for- profits, began to offer home health care services. Second, the rapid increase in home care expenditures prompted payers to drastically reduce reimbursement amounts just as new capacity emerged. In particular, the Centers for Medicare & Medicaid Services has reduced payment rates made under the home health prospective payment system for several years in a row Because of these changes, Southeastern's board of directors concluded that the company must start to apply state-of-the-art techniques in both its operations and its corporate managerial processes. As a first step, the board directed the financial vice president (VP) to develop an estimate for Pg. 80 106 Reader Contents Notebook Bookmarks 0.89K/s O 08:30 presiden Southeastern's cost of capital. The financial VP in turn, directed Southeastern's treasurer Clark Ruffin, to prepare and submit a cost-of- capital estimate in two weeks. He has an accounting background, and his primary task since taking over as treasurer has been cash and short-term liability management. Thus, he is somewhat apprehensive about his new assignment, an apprehension that is heightened by the fact that one board member is a well-regarded University of Florida finance professor. o develop an estimate To Clark began by reviewing Southeastern's 2017 financial statements (presented in exhibit 171 in simplified form) and by obtaining some selected market data (presented in exhibit 17.2). Next, he assembled the following data EXHIBIT 17.1 Southeastern Homecare: Balance Sheet $1. Cash and marketable securities Accounts receivable 25 5.9 2017 Financial Statement 1.0 Extracts Acoounts payable Pg. 80 107 Reader Contents Notebook Bookmarks 0.07K/s O 08:30 5.9 13 S 9.7 419 1.0 Extracts 0.2in Millions of Dollars) Inventory Notes payable Current assets Current liabilities Long-term debt Common stock Total liablities S 2.3 20.0 29.3 $51.6 Net fixed assets Total assets $516 Income Statement $80.6 71.8 2.8 6.0 Net revenues Cash expenses Taxable income Taxes Net income s 3.6 Additions to retained eamings 1.8 EXBIT 172 Expected Rate of Return on the Market Selected Market Data Expected rate of return on the S&P 500 Index 11.0% Required Rate of Return on Long-Term Debt of an Average Company Yield to maturity on A-rated long-term debt for a company with a beta of 1.0 = 70% Current Yield Curve on US Treasury Securities Term to Maturity 3 months 6 months 9 months 1 year 5 years 10 years 15 years 20 years 25 years 30 years 2.5% 3.0 3.3 3.5 4.0 4.5 4.8 5.0 5.2 lonn-Term Deht Pg. 80 107 Reader Contents Notebook Bookmarks 2.35K/s O 08:30 nformation Systems Division return 12.2% 13.2% A new healthcare recorg system Expanded billing software Clark has hired you as a consultant to develop Southeastern's overall corporate cost of capital. You will have to meet with the financial VP-and possibly with the president and the full board of directors (including the founders and the finance professor)-to present your findings and answer any questions. In addition to performing a standard analysis, you must address several concerns raised at the last board meeting about the cost-of-capital estimate. First, the board chair noted that the corporate cost-of-capital estimate is influenced by several factors, some of which are external to the business She is particularly interested in the impact on the estimated corporate cost of capital of factors that cannot be influenced by managerial actions. the divisional presidents questioned why a single cost of capital will be applied across the company, regardless of any divisional risk differences. Clark has askedyou to address this question by Second, SOUTHEASTERN HOMECARE COST OF CAPITAL 17 SOUTIBASTERN HOMECARE WAS founded m 1992 in Miama, Florida, au a satale partnership by Mana Gosales, MD, Ramon Garcia RN, and Ron Spacks, LPT. Its purpose is to peoside as a-home ahernative to hospitals and ambulatory care facilities for besic heelthcane services provided by physacians, registered natves, licmsed peactical surses, and physacal therapats (Foe more infoomation on home health services, see the websute of the National Association for Home Cae& Hosice at wwwnabc.o) Southeasters enjoyed esormous success froem the fist day of operations Even s funders were surpaed ast how eagy it was to establiab and run the bosimess Its founding coincided with the seerch by thard-paty payers foe altermative and poseshially less costly delirvery settiegs Because of its success in mesopolutan Mas Southeasters expanded services into Fort Lauderdale and West Pim Beach and then moved no othes metcopolatan areas in Florida and ac the U'S Souhrast Sostheasters aho expanded services at each location to snclude ocupatsional, speech, and rehabilitation therapies ne founders bad sut etal personal resources to start outheastem and they had enough confidence-ther bustness plan to commit mos of their own funds 1o the new venture However, afar umiy six yean. the external capital roquarements beought ot by rapid growth exhaustede fou des personal tinds. forrag them to banor leasih. Som a hough they still needed external cagetal to fiance growth, thes ability to boerow an ressonable rahes was exhusted Thus, it 2002 the foundere incorpoested Sowheesters asd, in 2005, sold commoes stock to the poblic through an mitial publi oftering. Todry, the fouoders still retais a large bat misosity ounernlop postio Southeasterm is widely recomized as one of the regional leades in the home heal care maustry In 2012, won an anrard for beine one of the 100 bestmanaged small companies in the Ueited Stanes It has two aperaline diviota Healthcaze Services and Infcemathon Systems The Heahthcare Services division operates the home health care senices dt all 22 locehoa Becesuse salea and cetngs im ais dinson aue selatively predicteble, the basiness risk of this devisson is abost average The lnfornation Systess divisios tns the computer sodhw are thar Southeastern desigsed to coestrol ats an opzationi and sells to other home health care comparan Tas sotware megrate"-vetery control nsit scheduling, chmeal record keeprze, billtag and coflections and payroll ito a single package Athough the software is exceest, it comgpetes head-to-bead wiah sevceal nagjor sofwase finmas well as uith other u_fermation wysem semres and inforttialot tanagement conainte tii Because oftascorertatson and s i The d Keys to it to ether home bealth care companues This software integrates ory collectioe, and payroll i firms as well as with other infomation system services and in the rapid teehmological changrs in the infoemation services business risk than does the Healtheane Services dinvsision control, visit schedaling, chinical secordkeeping, billng and into a single package. Although the sotware is excellent, it competes bead-to-hrad with several major sofrware ormatice management consuhing finns. Because of this competition and field, Southeasterm considers the Inforesation Systemsa davision to carry more Arhoueh its gmoeth bas bem exceptional Southrastern developod on a more ranfom thas plannced basih The foumders simpl decaded foe a new facility, tan an advertisement in a local neuspaper to het climical professionals and support staff, ant an exponenced manage hom an established afface to the new locatain, and began to make money aktaal in maalv Formal decison structures were almost monexistent, bur Southeasbern's head start and bnight, energetic founders easily overcame any deficiencies in Hawever, recent changes in the market for home health care services portend a more difficut envomment in the firtare. First, relatively generous paymment amousts in the 1990s and most of the 2000s produced istese cospetition in he home health care industry Other investor owned home bealth care agencies sprung up quickly, especially in majoe citirs, and several hospitals is Soudhrastes's service area, includinig not-for-profits, began to offer home health care services. Secoed, the rapid inczease in home care expenditures prompted pryers to drastically reduce reimbursement amounts jast as new capacity merand In particulxr, the Centers for Medicare & Medicaid Services has reduced payment rates made under the home health prospectne pe yment system for several year n are w Because of these dan es, southeastern's board of directors concluded diat de conpany murt topphr state-of-the-arT techniques in both its operations and its corporate anagerial procexs. As a Enst strp, the board directed the financial vice presedent (VP) to develop estimate for Southeasterna cost ufcaptal The financtal VP in turn, detted Soute titem's treanert Clark Ruffin to prepare and submit a cost-of-capital estiemate in two weeks He has an accounting backound, and his primary task soince taking over as treasueer has been cash and shoet-term liability managmest is, he is scmewhat apprebetsive abouat his sew agc heightened by the fact that one board member is a well-egaded Uain eity of Florsda fisance profece an apprchemsion thuet Clack began by seviewing Southeasteen's 2017 financial statements (peesentrd in gsbit 121 n smplified form) and by obtairing some selected market data (presented in exhibit 12 Nest, he mscmbled the followeg data s 11 2017 Financial Statoment Cash and marketable securities Accounts recevable 26 10 Extracts Notos paysble 02 in Millions of Dolars) Curent labilties 2 9029.1 @oegg Gapen." x Net foxed assets 41.9 Long-term debt Common stock Total liabilties 20.0 29.3 $51.6 Total assets $516 Income Statement Net revenues Cash expenses Depreciatiorn $80.6 71.8 2.8 s 6.0 2.4 3.6 1.8 1.8 Taxable income Taxes Net incorme Dividonds Additions to retained eamings EXHIBIT 172 Expacted Rate of Raturnm on the Marker Selected Market Data Expected fate of return on the S&P 500 Index-11.0% Required Rate of Raturn on Long-Term Debt of an Average Company Yield to maturity on A ated long-term debt for a company with a beta of 10-70% Curront Yiald Curve on US Treasury Secunithios arm to yiaid 3 months 2.5% . 25% 3.0 6 months 9 months 5 yoars 10 yoers 15 yegrs 20 yowrs 26 yoors 0 years 3.5 4.0 4.5 4.8 5.0 5.1 5.2 Long Term Debt theasten's long-term dete cst of 7.5 percint coupen, BBB-cated veniansual pasmene bonds with 15 yeas cemairing to maturity The bonds recently traded at a peice of 5956 11 per $1,000 par valse bond The bosds re caluble in five yeas at pa vabue plus & call permum of Ss0 for a total of $1.050 - The founders have an aversion to short-tem dete, so such Gebt is uied orily to fiand cyclical working copital needs. Sostsoste' financial plas calls for the asue of 30-year boade to meet long term debe nds Equity Southeastem's last dividend (DO) was 50.17, and its common mock now sells at a prce of 55.25 per share. The compony bon 20 mallion common sharex stodig In the past few years, Southeasters fas a raod a 20 percn an equty and bas paid out aboust 50 percest ofita nct incon as droidends Souheastems hissorical beta, as mcmurod by sereral asalyss uto follow the stock, falls to the rge of 1 3 to 15 Southrasters's hestorncal beta, as measured by several analysts who follow the stock falls in the range of 13 to 1.5 Capital Structure Southrastem's federal plas-state tax ate is 40 percent Southeastern's target capital structure mclodes weighes of 35 percent long-tem debe asd 65 percent common stock Operating Divisions Ahout 60 pencent of Southeastem's operating assets are used by the Healthcare Services division, and 40 percest by the Informatson Systems divission Masapement's best estimate of the Healtheare Services divoon's beta 10 Following are the two decasions wwwestment opportubes for next year Healthcare Senvaces De A ew office n Naples A r office S 9.3% Expanded ballngo Clark has luted you as a consultant to develop Southeestem's averall coeporate cost of capital. You wall have to meet with the finaacial nd the finence peofessoc-to present you addess several concems ratsed at the last board seetung about the cout-of- dhuat the corporate cost-of-capital estimuate is indluenced by several Eactoes, sonse of which are VP-ed possibly with the peesidens and the full board of durectors (including the founders a findmes and anowes any question capital estmate Fust, the board chair soted corporate c estrmal to de usiness She s petcularly interested an the a ls addinon to performing a standard anahsas, you must a mpact on the estimated corpocate cost of capital of factors hat cannor be acros the commpnyrgardless of as Second the r dnisonal presadests questioned wty a single cost of capital will be applied aczou the company dinsssonal nsk differesces C Clark has asked you to addeess thas question by developing drvisional costs of capital Thrd the founders alerted the group to dar thueat posed by home health care bssinesses atarted by not foe-profit hosperals, whach have oth com the sense that they do not pay diridends) and tax adv antages To help assess this threat, Clark has aked you to emmane the cost of capital Sor n aessge not-for-profit bospitals hosse Sealth case business, statine wath the snformation n esh Indomution Systems Dviso A new healthcare encord Expnded biling sodtware system 12.2% 13.2% Clark has hirrd you as a consultant to develop Southeasterm's overall corporate cast of capital. You will have to meet with the fiuscial findings and awwer any questions VP-and possibly with the pressdent and the fall board of darectors (including the founders and the finance professor) -to peesemt your capital nstimate Fust, the board chair strd tat the coepente caal-ofaptul estmae inflened by Xial frtors, sate of ulica are extermal to the business. She is particslarty unterested in the umpact on the estimatod corpoeatr cot of capital of factors that cannot be nfluenced by manageial actions divissonal risk differences. Clark has anked you to address ths question hy developing dinisonal costs of capital cont of capital foe an anverage sot-for profit haepinal's home health care busnes Second, the divisional presidemts questioned why a single cost of capital will be applied across the compaxy, segardless of any Thard, the fornders alested the group to the deeat posed by home bealth care bsinea started by not for-peofit bospitals, which have the sense that they do not pey drvidends) and tax advanmares To help asess thais threat Clark has asked you ta estimate te , stoaerting with the informathos in sshibst 173 Tarm Ccital Stucs Selected Not-for-Profit 30 parcent dabt Hospital Data rnt equity Inst assets Avarage Cost of Deer Interest ratean arated taroempr borde-50% at CASE SOUTHEASTERN HOMECARE COST OF CAPITAL SOUTHEASTERN HOMECARE WAS founded in 1992 in Miami, Florida, as a taxable partnership by Maria Gonzalez, MD; Ramon Garcia, RN; and Ron Sparks, LPT. lts purpose is to provide an at-home alternative to hospitals and ambulatory care facilities for basic healthcare services provided by physicians, registered nurses, licensed practical nurses, and physical therapists. (For more information on home health services Pg. 80 105 Reader Contents Notebook Bookmarks 0.05K/s O08:29 more information on home health services, see the website of the National Association for Home Care & Hospice at www.nahc.org.) Southeastern enjoyed enormous success from the first day of operations. Even its founders were surprised at how easy it was to establish and run the business. Its founding coincided with the search by third- party payers for alternative and potentially less costly delivery settings. Because of its success in metropolitan Miami, Southeastern expanded services into Fort Lauderdale and West Palm Beach and then moved into other metropolitan areas in Florida and across the US Southeast. Southeastern also expanded services at each location to include occupational, speech, and rehabilitation therapies The founders had sufficient personal resources to start Southeastern, and they had enough confidence in their business plan to commit most of their own funds to the new Pg. 80 105 Reader Contents Notebook Bookmarks 0.7K/sO08:29 commit most of their own funds to the new venture. However, after only six years, the external capital requirements brought on by rapid growth exhausted the founders' personal funds, forcing them to borrow heavily. Soon, although they still needed external capital to finance growth, their ability to borrow at reasonable rates was exhausted Thus, in 2002, the founders incorporated Southeastern and, in 2005, sold commorn stock to the public through an initial public offering. Today, the founders stil retain a large but minority ownership position at Southeastern, and the Southeastern stock trades in the over-the-counter market Southeastern is widely recognized as one of the regional leaders in the home health care industry. In 2012, it won an award for being one of the 100 best-managed small companies in the United States. It has two operating divisions: Healthcare Services and Information Systems. The Healthcare Pg. 80 105 Reader Contents Notebook Bookmarks 0.14K/s O 08:30 nformation Systems Services division operates the home health care services atall22 locations. Because sales and earnings in this division are relatively predictable, the business risk of this division is about average. ealthcare The Information Systems division maintains the computer software that Southeastern designed to control its own operations and sells it to other home health care companies. This software integrates inventory control, visit scheduling, clinical record keeping, billing and collections, and payroll into a single package. Although the software is excellent, it competes head-to- head with several major software firms as well as with other information system services and information management consulting firms. Because of this competition and the rapid technological changes in the information services field, Southeastern considers the Information Systems division Pg. 80 106 Reader Contents Notebook Bookmarks 0.08K/s O 08:30 to carry more business risk than does the Healthcare Services division. Although its growth has been exceptional, Southeastern developed on a more random than planned basis. The founders simply decided on a location for a new facility, ran an advertisement in a local newspaper to hire clinical professionals and support staff, sent an experienced manager from an established office to the new location, and began to make money almost immediately. Formal decision structures were almost nonexistent, but Southeastern's head start and bright, energetic founders easily overcame any deficiencies in managerial decision-making processes However, recent changes in the market for home health care services portend a more difficult environment in the future. First, relatively generous payment amounts in the 1990s and most of the 2000s produced Pg. 80 106 Reader Contents Notebook Bookmarks 0.89K/s O 08:30 intense competition in the home health care industry. Other investor-owned home health care agencies sprung up quickly, especially in major cities, and several hospitals in Southeastern's service area, including not-for- profits, began to offer home health care services. Second, the rapid increase in home care expenditures prompted payers to drastically reduce reimbursement amounts just as new capacity emerged. In particular, the Centers for Medicare & Medicaid Services has reduced payment rates made under the home health prospective payment system for several years in a row Because of these changes, Southeastern's board of directors concluded that the company must start to apply state-of-the-art techniques in both its operations and its corporate managerial processes. As a first step, the board directed the financial vice president (VP) to develop an estimate for Pg. 80 106 Reader Contents Notebook Bookmarks 0.89K/s O 08:30 presiden Southeastern's cost of capital. The financial VP in turn, directed Southeastern's treasurer Clark Ruffin, to prepare and submit a cost-of- capital estimate in two weeks. He has an accounting background, and his primary task since taking over as treasurer has been cash and short-term liability management. Thus, he is somewhat apprehensive about his new assignment, an apprehension that is heightened by the fact that one board member is a well-regarded University of Florida finance professor. o develop an estimate To Clark began by reviewing Southeastern's 2017 financial statements (presented in exhibit 171 in simplified form) and by obtaining some selected market data (presented in exhibit 17.2). Next, he assembled the following data EXHIBIT 17.1 Southeastern Homecare: Balance Sheet $1. Cash and marketable securities Accounts receivable 25 5.9 2017 Financial Statement 1.0 Extracts Acoounts payable Pg. 80 107 Reader Contents Notebook Bookmarks 0.07K/s O 08:30 5.9 13 S 9.7 419 1.0 Extracts 0.2in Millions of Dollars) Inventory Notes payable Current assets Current liabilities Long-term debt Common stock Total liablities S 2.3 20.0 29.3 $51.6 Net fixed assets Total assets $516 Income Statement $80.6 71.8 2.8 6.0 Net revenues Cash expenses Taxable income Taxes Net income s 3.6 Additions to retained eamings 1.8 EXBIT 172 Expected Rate of Return on the Market Selected Market Data Expected rate of return on the S&P 500 Index 11.0% Required Rate of Return on Long-Term Debt of an Average Company Yield to maturity on A-rated long-term debt for a company with a beta of 1.0 = 70% Current Yield Curve on US Treasury Securities Term to Maturity 3 months 6 months 9 months 1 year 5 years 10 years 15 years 20 years 25 years 30 years 2.5% 3.0 3.3 3.5 4.0 4.5 4.8 5.0 5.2 lonn-Term Deht Pg. 80 107 Reader Contents Notebook Bookmarks 2.35K/s O 08:30 nformation Systems Division return 12.2% 13.2% A new healthcare recorg system Expanded billing software Clark has hired you as a consultant to develop Southeastern's overall corporate cost of capital. You will have to meet with the financial VP-and possibly with the president and the full board of directors (including the founders and the finance professor)-to present your findings and answer any questions. In addition to performing a standard analysis, you must address several concerns raised at the last board meeting about the cost-of-capital estimate. First, the board chair noted that the corporate cost-of-capital estimate is influenced by several factors, some of which are external to the business She is particularly interested in the impact on the estimated corporate cost of capital of factors that cannot be influenced by managerial actions. the divisional presidents questioned why a single cost of capital will be applied across the company, regardless of any divisional risk differences. Clark has askedyou to address this question by Second