PROBLEM 3
Columbia Home Care Inc. is considering a merger with HCA Home Care Inc. HCA is a publicly
traded company, and its current beta is 1.30. HCA has been barely profitable and had paid an average
of only 20 percent in taxes during the last several years. In addition, it uses little debt, having a debt
ratio of just 25 percent. If the acquisition were made, Columbia would operate HCA as a separate,
wholly owned subsidiary. Columbia would pay taxes on a consolidated basis, and the tax rate would
therefore increase to 35 percent. Columbia also would increase the debt capitalization in the HCA
subsidiary to 40 percent of assets, which would increase its beta to 1.50. Columbia estimates that
HCA, if acquired, would produce the following net cash flows to Columbia's shareholders (in millions
of dollars):
Year	Free Cash Flows to Equityholders
1	$1.30
2	$1.50
3	$1.75
4	$2.00
5 and beyond	Constant growth at 6%
These cash flows include all acquisition effects. Columbia's cost of equity is 14 percent, its beta is 1.0,
and its cost of debt is 10 percent. The risk-free rate is 8 percent.
a. What discount rate should be used to discount the estimated cash flow? (Hint: Use Columbia's cost of
equity to determine the market risk premium.)
b. What is the dollar value of HCA to Columbia's shareholders?