CASE 18		Student Version				Copyright 2014 Health Administration Press
6/17/2016
		SOUTHEASTERN HOMECARE
		Cost of Capital
This case illustrates the cost of capital estimation for a business with two divisions that
operate in diverse business lines.
The spreadsheet calculates the cost of debt based on the yield to maturity and the yield
to call of debt issues that are currently outstanding. It also calculates the cost of equity on
the basis of three models: CAPM, DCF, and Debt Cost + Risk Premium.
Students must use judgment when making the final estimates for the costs of debt and equity.
These estimates must be entered into the lower part of the INPUT DATA section to calculate
the corporate cost of capital. Divisional costs of capital can be estimated using the same
part of this spreadsheet, but with the appropriate divisional input data.
The model consists of a complete base case analysishowever, all values in the INPUT DATA
section of the student version have been replaced with zeros. Thus, students must determine
the appropriate input values and enter them into the model. These cells are colored red.
When this is done, any error cells will be corrected and the base case solution will appear.
Note that the model does not contain any risk analyses, so students will have to create
their own if required by the case. Furthermore, students must create their own graphics
(charts) as needed to present their results.
INPUT DATA:				KEY OUTPUT:
Cost of Debt Input:				Cost of Debt:
Years to maturity		5		YTM	0.9%
Annual coupon payment		$0.08		YTC	2.0%
Current price		$956.31
Par value		$1,000.00
Years to call		5
Call price		$1,057.00
Cost of Equity Input:				Cost of Equity:
CAPM Approach:
Beta coefficient		1.4		CAPM	13.4%
Risk-free rate		5.0%
Required market return		11.0%
DCF Approach:
Stock price		$5.25		DCF	13.6%
Last dividend paid		$0.17
Constant growth rate		10.0%
Debt Cost Plus RP Approach:
Risk premium		4.0%		DC+RP	4.9%
Corporate Cost of Capital Input:				Corporate Cost of Capital:
Tax rate		40.0%		CCC	51.8%
Weight of debt		35.0%
Weight of equity		65.0%
Final cost of debt estimate		30.0%
Final cost of equity estimate		70.0%

Cases in Healthcare Finance, 5

th

Edition Copyright 2014 Health Administration Press

12/6/2013

CASE 18 QUESTIONS

SOUTHEASTERN HOMECARE

Cost of Capital

1. What corporate cost of capital (CCC)

do you estimate for Southeastern Homecare?

2. The companys financial plan calls for the iss

ue of 30-year bonds to meet

long-term debt needs. How

valid is an estimate of the cost of debt based on 15-ye

ar bonds? If the estimate is

not valid, how might it

be adjusted to remove any bias?

3. The Board Chair is concerned about factors that affe

ct the corporate cost of capital for any business:

the level of interest rates, tax rates, capital struct

ure policy, and capital invest

ment policy. Does the tax

rate, cost of debt, or cost of equity have the

most influence on the CCC of Southeastern Homecare?

Why? (Hint: In one graph, show the CCC at +/- 25%

and 50% values of the tax rate, cost of debt, and

cost of equity.)

4. Southeastern Homecare has two

operating divisions: the Health

care Services Division and the

Information Systems Division.

a. Estimate the divisional cost of capital for

each of Southeasterns divi

sions assuming that both

divisions have the same optimal (target) capital st

ructure. (Hint: Use the CAPM to produce a cost

of equity for each division and assume the same

corporate tax rate and debt cost for each

division.)

b. Southeasterns divisions are each considering two

investment opportunities for next year. In which

of the projects should Southeastern invest?

c. The divisional presidents have expressed concern

that a single cost of capital will be applied across

the company, regardless of any divisional risk diffe

rences. What would be the short-term and long-

term consequences of Southeastern using a si

ngle cost of capital for both divisions?

d. Is the divisional cost of

capital applicable for all projects

within that division? Explain.

e. Suppose that one division has a greater capacit

y for debt financing than the other (perhaps due to

higher asset value and profitability.) How could di

fferent target capital structures be incorporated

into the divisional costs of capital?

5. The founders of Southeastern are concerned about the threat posed by home health care businesses

started by not-for-profit hospitals. Using your ans

wer to Question 4a and the data in Table 18.3,

estimate the cost of capital for the homecare divisi

on of an average not-for-profit hospital. How much

confidence do you have in the cost of capital estimate? Why?

6. One of Southeasterns directors has express

ed concern over the difference between the companys

target capital structure and the current st

ructure as reported on the balance sheet.

a. What are the book values of Southeasterns

long-term debt and equity? What are the current

market values of Southeasterns long-term debt and equity?

b. What are Southeasterns target

weights, book value weights, and current market value weights of

long-term debt and equity (that is, long-term debt /

total capital and common stock / total capital)?

c. Which set of weights should be used in t

he corporate cost of capital estimate? Why?