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### UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 7 -- Equity Financing PROBLEM 1 A person is considering buying the stock of two home health companies that are similar in all respects except for the proportion of earnings paid out as dividends. Both companies are expected to earn $6 per share in the coming year, but Company D (for dividends) is expected to pay out the entire amount one year from now as dividends, while Company G (for growth) is expected to pay out only one-third of its earnings or $2 per share. The companies are equally risky, and their required rate of return is 15 percent. D's constant growth rate is zero and G's is 8.33 percent. What are the expected prices of Stocks D and G? ANSWER UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 7 -- Equity Financing PROBLEM 2 Medical Corporation of America (MCA) has a current stock price of $36, and its last dividend (D0) was $2.40. In view of MCA's strong financial position, its required rate of return is 12 percent. If MCA's dividends are expected to grow at a constant rate in the future, what is the firm's expected stock price in five years? ANSWER Last dividend pa $2.40 Expected growth10.0% Required rate of 12.0% Stock price Number of years $36.00 5 E(Dt)= D0 * [1+ E(g)]t E(D1)= E(D2)= E(D3)= E(D4)= E(D5)= The expected price of this stock in 5 years Stock price * (1+G)N E(P5) = 57.978 2.640 2.904 3.194 3.514 3.865 16.117 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 7 -- Equity Financing PROBLEM 3 A broker offers to sell you shares of Bay Area Healthcare, which just paid a dividend of $2 per share. The dividend is expected to grow at a constant rate of 5 percent per year. The stock's required rate of return is 12 percent. a. What is the expected dollar dividend over the next three years? b. What is the current value of the stock and the expected stock price at the end of each of the next three years? c. What is the expected dividend yield and capital gains yield for each of the next three years? d. What is the expected total return for each of the next three years? How does the expected total return compare with the required rate of return on the stock? Does this make sense? Explain your answer. ANSWER Dividend paid Constant growth rate Required rate of return a E(Dt)= D0 * [1+ E(g)]t E(D1)= E(D2)= E(D3)= b $2.00 5.0% 12.00% 2.100 2.205 2.315 Current value of the stock $17.40 306.25 ??? Assuming that the stock is in equilibrium so the R(Rs)=E(Rs) E 1= E 2= E 3= 17.07% 17.67% 18.31% Expected price of the stock Stock price * (1+G)N E(P) = c 18.270 Year 1 E(D1)= 19.184 Year 2 E(D2)= 20.143 Year 3 E(D3)= 57.596 2.100 2.205 2.315 Dividend Yield = Expected Dividend/ stock price 11.49% 11.49% 11.49% Capital gains yield= Capital gain / Beginning price 17.27 18.18 19.14 d Expected total return for each of the next three years 53.05% How does the expected total return compare with the required rate of return on the stock? Does this make sense? Explain your ans??? Total expected return 1 20.370 2 21.389 Required return Price Dividend total 3 22.458 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 7 -- Equity Financing PROBLEM 4 Assume the risk-free rate is 6 percent and the market risk premium is 6 percent. The stock of Physicians Care Network (PCN) has a beta of 1.5. The last dividend paid by PCN (D0) was $2 per share. a. What would PCN's stock value be if the dividend was expected to grow at a constant -5 percent? 0 percent? 5 percent? 10 percent? b. What would be the stock value if the growth rate is 10 percent, but PCN's beta falls to 1.0? 0.5? ANSWER 6% RF Risk-free rate 6% R(Pm) Market Risk peremium[ R(Rm)- RF)] 1.5 b Beta coefficent 15.00% R $2 D0 Required rate of return Last dividend a Growth rate -5% Stock value b Growth rate Beta coefficent 10% 1 10% 0.5 0% 5% 10% UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 7 -- Equity Financing PROBLEM 5 Better Life Nursing Home, Inc., has maintained a dividend payment of $4 per share for many years. The same dollar dividend is expected to be paid in future years. If investors require a 12 percent rate of return on investments of similar risk, determine the value of the company's stock. ANSWER Dividend payment Rate of return $ 4.00 12% Value of the company's stock 33.333 UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 7 -- Equity Financing PROBLEM 6 Jane's sister-in-law, a stockbroker at Invest, Inc., is trying to get Jane to buy the stock of HealthWest, a regional HMO. The stock has a current market price of $25, its last dividend (D0) was $2, and the company's earnings and dividends are expected to increase at a constant growth rate of 10 percent. The required return on this stock is 20 percent. From a strict valuation standpoint, should Jane buy the stock? ANSWER Not in the homework UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 7 -- Equity Financing PROBLEM 7 Lucas Clinic's last dividend (D0) was $1.50. Its current equilibrium stock price is $15.75, and its expected growth rate is a constant 5 percent. If the stockholders' required rate of return is 15 percent, what is the expected dividend yield and expected capital gains yield for the coming year? ANSWER Not in the homework UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 7 -- Equity Financing PROBLEM 8 St. John Medical, a surgical equipment manufacturer, has been hit hard by increased competition. Analysts predict that earnings and dividends will decline at a rate of 5 percent annually into the foreseeable future. If the firm's last dividend (D0) was $2, and investors' required rate of return is 15 percent, what will be the company's stock price in three years? ANSWER Not in the homework UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 7 -- Equity Financing PROBLEM 9 California Clinics, an investor-owned chain of ambulatory care clinics, just paid a dividend of $2 per share. The firm's dividend is expected to grow at a constant rate of 5 percent per year, and investors require a 15 percent rate of return on the stock. a. What is the stock's value? b. Suppose the riskiness of the stock decreases, which causes the required rate of return to fall to 13 percent. Under these conditions, what is the stock's value? c. Return to the original 15 percent required rate of return. Assume that the dividend growth rate estimate is increased to a constant 7 percent per year. What is the stock's value? ANSWER Last dividend paid Constant growth rate Required rate of return $2.00 5.0% 15.00% a Stock value= Expected dividend / Required rate of return $ 13.95 b Last dividend paid Constant growth rate Required rate of return Stock value c $ $2.00 5.0% 13.00% 16.10 Last dividend paid Constant growth rate Required rate of return Stock value $ $2.00 7.0% 15.00% 14.20 A B C D 2 Chapter 7 -- Equity Financing 3 4 5 7 8 9 PROBLEM 10 Conner Health Inc. has a stock price of $32.35 per share. The last dividend (D0) was $3.42. The long-run growth rate for the company is a constant 7 percent. What is the company's capital gains yield and dividend yield? 10 11 12 13 Stock price Last dividend(D0) Expected LT growth rate $ $ 32.35 3.42 7% 14 15 Expected total return on the stock 17.57% 16 17 18 E(D1) E(D2) $ $ 3.42 3.66 E(P1)=E(D2) /R(Rm)-E( g) $ 20.76 Capital gains of$32.35-$20.76 is $ 11.59 19 20 21 22 23 24 Capital gains yield= Capital gain/ beginning price 36% 25 26 27 If the analysis was extended in the future year the expected capital gains yields would always equal E(g) because the stock price would gro at the 36% constant dividend rate. 28 29 Dividend yield= Expected dividend / Stock price 30 31 F UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT 1 6 E The expected dividend's yield is a constant. 18%