CHAPTER 9 UHFM 6TH EDITION

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 15.0% Beverly Enterprises 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? ANSWER 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 5/1/10 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 Associate'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 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