Southeastern Homecare Cost of Capital:

Balance sheet (millions of dollars
Cash and marketable securities	$2.5	Accounts payable	$1.1
Accounts receivable	5.9	Accruals	1.0
Inventory	1.3	Notes payable	0.2
Current assets	9.7	Current liabilities	2.3
Net Fixed Assets	32.9	Long-term debt	20.0
		Common stock	20.3
Total Assets	42.6	Total liabilities	42.6

Income statement
Net revenue	$80.6
Cash expenses	71.8
Depreciation	2.8
Taxable income	6.0
Taxes	2.4
Net income	3.6
Dividends	1.8
Additions to retained earnings	1.8

1. Southerns long-term debt consists of 7.5 percent coupon, BBB-rated, semiannual payment bonds with 15 years remaining to maturity. The bonds recently traded at a price of $956.31 per $1,000 par value bond. The bonds are callable in five years at par value plus a call premium of one years interest, for a total of $1,075.

2. The founders have an aversion to short-term debt, so the company uses such debt only to fund cyclical working capital needs. The companys financial plan calls for the issue of 30-year bonds to meet long-term debt needs.

3. Southerns federal-plus-state tax rate is 40 percent.

4. Southerns last dividend (D0) was $0.18, and most analysts predict the companys dividend to grow at a relatively constant annual rate somewhere in the range of 8 percent to 12 percent. Southerns common stock now sells at a price of $5.25 per share. The company has 10 million common shares outstanding.

5. Over the last few years, Southern has averaged a 20 percent return on equity and has paid out about 50 percent of its net income as dividends.

6. The current yield curve on U.S. Treasury securities is as follows:

Term to maturity	Yield
3 months	2.5%
6 months	3
9 months	3.3
1 year	3.5
5 years	4.0
10 years	4.5
15 years	4.8
20 years	5.0
25 years	5.1
30 years	5.2

7. A prominent investment banking firm has recently estimated the expected rate of return on the S&P 500 Index to be 11 percent.

8. Southerns historical beta, as measured by several analysts who follow the stock, falls in the range of 1.3 to 1.5.

9. The required rate of return on an average (A-rated, beta = 1.0) companys long-term debt is 7 percent.

10. Southerns market value target capital structure calls for 35 percent long-term debt and 65 percent common stock.

11. Clark is aware of a third method (in addition to the capital asset pricing and discounted cash flow models) for estimating a firms cost of equity: the bond yield plus risk-premium method. Here, a risk premium is added to the firms own before-tax cost-of-debt estimate to obtain an estimate of the cost of equity. Note that the risk premium used here is not the market risk premium, which is applied to the risk-free rate. Rather, the risk premium reflects the difference between an average firms cost of equity and its cost of debt.

12. About 60 percent of Southerns operating assets are used by the Healthcare Services Division, and 40 percent are used by the Information Systems Division. Managements best estimate of the beta of its Healthcare Services Division is 1.0.

Assume that Clark has hired you as a consultant to develop Southerns overall corporate cost of capital. You will have to meet with the financial VP and, possibly, with the president and the full board of directors (including the founders and the finance professor) to present your findings and answer any questions they might have.

In addition to the standard analysis, several issues related to the cost of capital estimate were raised at the last executive committee meeting. First, it is clear that cost of capital estimates are subject to significant uncertainty. Although a point (single) estimate is necessary, it would also be useful to get some idea of the corporate cost of capitals uncertainty by estimating its potential range of values.

Second, the divisional presidents expressed concern that a single cost of capital will be applied across the company, regardless of any divisional risk differences. Clark has asked you to be sure to address their concerns. Specifically, he wants you to develop divisional costs of capital in addition to the overall corporate cost of capital.

Third, the founders of Southern are very concerned about the threat posed by home health care businesses started by not-for-profit hospitals because they have both cost (in the sense that they do not pay dividends) and tax advantages. To help assess the threat, Clark has asked you to use the information developed for Southern, along with the not-for-profit hospital data contained in Exhibit 16.2, to estimate the cost of capital for an average not-for-profit hospitals home health care business.

EXHIBIT 16.2: Selected Not-for-Profit Hospital Data

Average Long-Term Capital Structure:

30 percent debt

70 percent equity (fund capital)

Average Cost of Debt:

Interest rate on A-rated tax-exempt bonds = 5.0%

Finally, one of Southerns directors has expressed concern over the difference between the companys target capital structure and the current structure as reported on the balance sheet. Clark wondered if this should be a matter of concern.