SOUTHERN HOMECARE was founded in 1992 in Miami, Florida, as a taxable partnership by Mara Gonzlez, MD, Ramn Garca, RN; and Ron Sparks, LPT. Its purpose was to provide an at-home alternative to hospitals and ambulatory care facilities for basic healthcare services provided by physicians, register nurses, licensed practical nurses, and physical therapists. (For more information on home health services, see the website of the National Association for Home Care & Hospice at www.nahc.org.) The partnership enjoyed enormous success in the beginning. Even its founders were surprised at how easy the business was to establish and run. Formation of the company coincided with the search by third-party payers for alternative, and potentially less costly, delivery settings. On the basis of its success in metropolitan Miami, the partnership expanded services into Fort Lauderdale and West Palm Beach and then moved into other metropolitan areas in Florida and across the Southeast. The partnership also expanded services at each location to include occupational, speech, and rehabilitation therapies. The founders had sufficient personal resources to start the company, and they had enough confidence in their business plan to commit most of their own funds to the new venture. However, after only six years, the external capital requirements brought on by rapid growth exhausted their personal funds, and they were forced to borrow heavily. Soon, although they still needed external capital to finance growth, the founders ability to borrow at reasonable rates was exhausted. Thus, in 2002 they incorporated the partnership, and in 2005 they sold common stock to the public through an initial public offering (IPO). The founders still retain a large, but minority, ownership position in the company, and currently the stock trades in the over-the-counter market. Southern is widely recognized as one of the regional leaders in its industry, and it won an award in 2008 for being one of the 100 best-managed small companies in the United States. The company has two operating divisions: (1) the Healthcare Services Division and (2) the Information Systems Division. The Healthcare Services Division operates Southerns home health care services in 22 locations. Because sales and earnings in this division are relatively predictable, the divisions business risk is about average. The Information Systems Division sells the computer software system that Southern designed to control its own operations to other home health care companies. This system combines inventory control, visit scheduling, clinical record keeping, billing and collections, and payroll into a single integrated package. Although the system is excellent, this division competes head to head with several major software firms as well as with information services and management consulting firms. Because of this competition, and the rapid technological changes inherent in the information services field, Southerns management considers the Information Systems Division to have more business risk than the Healthcare Services Division. Although the companys growth was exceptional, it was more random than planned. The founders simply decided on a location for a new office, ran an advertisement in a local newspaper to recruit clinical professionals and clerical employees, sent in an experienced manager from one of the established offices, and began to make money almost immediately. Formal decision structures were almost nonexistent, but the companys head start and its bright, energetic founders easily overcame any deficiencies in managerial decision-making processes. However, recent changes in the market for home health care services portend a much more difficult environment in the future. First, relatively generous payment amounts in the 1990s and most of the 2000s produced intense competition in the home health care industry. Other investor-owned home health care firms sprang up like weeds, especially in major cities, and several hospitals in Southerns service area, including not-for-profits, began to offer home health care services. Second, the rapid increase in expenditures on home health care services prompted payers to drastically reduce reimbursement amounts, just as new capacity come on line. In particular, the Balanced Budget act of 1997 mandated lower payment amounts for Medicare home health services, which resulted in a totally new prospective payment system (PPS). (For information on PPS, see www.cms.hhs.gov/center/hha.asp.) Because of these changes, Southerns board of directors concluded that the company must start to apply state-of-the-art techniques in both its operations and its corporate managerial processes. As a first step, the board directed the financial vice president (VP) to develop an estimate for the companys cost of capital. The financial VP, in turn, directed Southerns treasurer, Clark Ruffin, to prepare and submit a cost-of-capital estimate in two weeks. Clark has an accounting background, and his primary task since taking over as treasurer has been cash and short-term liability management. Thus, he is somewhat apprehensive about his new assignment, an apprehension that is heightened by the fact that one board member is a well-regarded University of Florida finance professor. Clark began by reviewing Southerns 2009 financial statements, which are presented in Exhibit 16.1 in simplified form. Next, he assembled the following data:

1. Southerna long-term debt consist of 7.5 percent coupon, BBB-rated, semiannual payment bonds with 15 years remaining to maturity. The bonds recently traded at a price of 956.31per $1,000 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-years 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, Southerns has averaged a 20 percent return on equality 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	3.0
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 od debt.

12. About 60 percent of Souterns 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 Health-care Services Division is 1.0.

Part 1:

a. What is your estimate of Southerns cost of debt?

b. What is the companys estimated cost of equity using the CAPM approach?

c. Use the discounted cash flow (DCF) method to obtain a cost of equity estimate.

d. Use the debt cost (bond yield) plus risk premium method to estimate the cost of equity.

e. What is your final estimate for Southerns cost of equity? Explain your answer.

Part 2:

What is your estimate for Southerns corporate cost of capital?

Part 3:

What are Southerns book value and market value weights of long-term debt and equity? Which set of weights should be used in the corporate cost of capital estimate? Why? (Hint: Use the book value of the debt and the current bond price as a percentage of par to obtain the market value of debt. Use the number of shares outstanding and the market price per share to obtain the market value of equity.)

EXHIBIT 16.1

Southern Homecare:

2009 Financial Statement Extracts

Balance Sheet ($):

Cash and marketable securities	2,500,000
Accounts receivable	5,900,000
Inventory
Current assets	9,700,000
Net fixed assets	32,900,000
Total assets	42,600,000
Accounts payable	1,100,000
Accruals	1,000,000
Notes payable	200,000
Current liabilities	2,300,000
Long-term debt	20,000,000
Common stock	20,300,000
Total claims	42,600,000

Income Statement ($):

Net revenues	80,600,000
Cash expenses	71,800,000
Depreciation	2,800,000
Taxable income	6,000,000
Taxes	2,400,000
Net income	3,600,000
Dividends	1,800,000
Additions to retained earnings	1,800,000

EXHIBIT 16.2

Select 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%