Chapter 9 Problem 5

Morningside Nursing Home, a single not-for-profit facility, is estimating its corporate cost of capital. Itstax-exempt debt currently requires an interest rate of 6.2 percent, and its target capital structure callsfor 60 percent debt financing and 40 percent equity (fund capital) financing. The estimated costs ofequity for selected investor-owned healthcare companies are given below:

Glaxo Welcome = 15%

Beverly Enterprise=16.4%

HEALTHSOUTH=17.4%

Humana=18.8%

a. What is the best estimate for Morningside's cost of equity?

b. What is the firm's corporate cost of capital?

9/1/2014 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 1 Calculate the after-tax cost of debt for the Wallace Clinic, a for-profit healthcare provider, assuming that the coupon rate set on its debt is 11 percent and its tax rate is: a. 0 percent b. 20 percent c. 40 percent ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 2 St. Vincent's Hospital has a target capital structure of 35 percent debt and 65 percent equity. Its cost of equity (fund capital) estimate is 13.5 percent and its cost of tax-exempt debt estimate is 7 percent. What is the hospital's corporate cost of capital? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 3 Richmond Clinic has obtained the following estimates for its costs of debt and equity at various capital structures: Percent Debt 0% 20% 40% 60% 80% After-Tax Cost of Debt 6.6% 7.8% 10.2% 14.0% Cost of Equity 16% 17% 19% 22% 27% What is the firm's optimal capital structure? (Hint: Calculate its corporate cost of capital at each structure. Also, note that data on component costs at alternative capital structures are not reliable in real-world situations.) ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 4 Medical Associates is a large for-profit group practice. Its dividends are expected to grow at a constant rate of 7 percent per year into the foreseeable future. The firm's last dividend (D0) was $2, and its current stock price is $23. The firm's beta coefficient is 1.6; the rate of return on 20-year T-bonds is 9 percent; and the expected rate of return on the market, as reported by a large financial services firm, is 13 percent. The firm's target capital structure calls for 50 percent debt financing, the interest rate required on the business's new debt is 10 percent, and its tax rate is 40 percent. a. What is Medical Associates' cost of equity estimate according to the DCF method? b. What is the cost of equity estimate according to the CAPM? c. On the basis of your answers to Parts a. and b., what would be your final estimate for the firm's cost of equity? d. What is your estimate for the firm's corporate cost of capital? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 5 Morningside Nursing Home, a single not-for-profit facility, is estimating its corporate cost of capital. Its tax-exempt debt currently requires an interest rate of 6.2 percent, and its target capital structure calls for 60 percent debt financing and 40 percent equity (fund capital) financing. The estimated costs of equity for selected investor-owned healthcare companies are given below: Glaxo Wellcome Beverly Enterprises HEALTHSOUTH Humana 15.0% 16.4% 17.4% 18.8% a. What is the best estimate for Morningside's cost of equity? b. What is the firm's corporate cost of capital? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 6 Golden State Home Health, Inc., is a large, California-based for-profit home health agency. Its dividends are expected to grow at a constant rate of 5 percent per year into the foreseeable future. The firm's last dividend (D0) was $1, and its current stock price is $10. The firm's beta coefficient is 1.2; the rate of return on 20-year T-bonds currently is 8 percent; and the expected rate of return on the market, as reported by a large financial services firm, is 14 percent. Golden State's target capital structure calls for 60 percent debt financing, the interest rate required on its new debt is 9 percent, and the firm's tax rate is 30 percent. a. What is the firm's cost of equity estimate according to the DCF method? b. What is the cost of equity estimate according to the CAPM? c. On the basis of your answers to Parts a. and b., what would be your final estimate for the firm's cost of equity? d. What is your estimate for the firm's corporate cost of capital? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 7 An analyst has collected the following information regarding Christopher Healthcare: - The company's capital structure is 70 percent equity, 30 percent debt. - The yield to maturity on the company's bonds is 9 percent. - The company's year-end dividend is forecasted to be $0.80 a share. - The company expects that its dividend will grow at a constant rate of 9 percent a year. - The company's stock price is $25. - The company's tax rate is 40 percent. - The company anticipates that it will need to raise new common stock this year. Its investment bankers anticipate that the total flotation cost will equal 10 percent of the amount issued. Assume the company accounts for flotation costs by adjusting the cost of capital. Given this information, calculate the company's CCC. ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 8 Grateway Inc. has a corporate cost of capital of 11.5 percent. Its target capital structure is 55 percent equity and 45 percent debt. The before-tax cost of debt is 9 percent, and the company's tax rate is 30 percent. If the expected dividend next period (D1) and current stock price are $5 and $45, respectively, what is the company's growth rate? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 9 USC Health's balance sheets show a total of $30 million long-term debt with a coupon rate of 9 percent. The yield to maturity on this debt is 11.11 percent, and the debt has a total current market value of $25 million. The balance sheets also show that that the company has 10 million shares of stock; the total of common stock and retained earnings is $30 million. The current stock price is $7.5 per share. The return required by stockholders, R(Re), is 12 percent. The company has a target capital structure of 40 percent debt and 60 percent equity. The tax rate rate is 40 percent. What corporate cost of capital should you use to evaluate potential projects? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 -- Cost of Capital PROBLEM 10 A stock analyst has obtained the following information about J-Mart, a large pharmacy chain: - The company has noncallable bonds with 20 years maturity remaining and a maturity value of $1,000. The bonds have a 12 percent annual coupon and currently sell at a price of $1,273.86. - Over the past four years, the returns on the market and on J-Mart were as follows: Year Market J-Mart 1 12.0% 14.5% 2 17.2% 22.2% 3 -3.8% -7.5% 4 20.0% 24.0% - The risk-free rate is 6.35 percent, and the expected return on the market is 11.35 percent. The company's tax rate is 35 percent. The company anticipates that its proposed investment projects will be financed with 70 percent debt and 30 percent equity. What is the company's estimated corporate cost of capital (CCC)