What is Southeasterns cost of debt?

Suppose the companys outstanding debt had not been recently traded; what other methods could be used to estimate the cost of debt?

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

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5 / 10 100% + 1 0 0 SOUTHEASTERN HOMECARE WAS founded in 1992 in Miami, Florida, as a taxable partnership by Maria Gonzalez, MD; Ramon Garcia, RN; and Ron Sparks, LPT. Its purpose is to provide an at-home alternative to hospitals and ambulatory care facilities for basic healthcare services provided by physi- cians, registered 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.) Southeastern enjoyed enormous success from the first day of operations. Even its founders were surprised at how easy it was to establish and run the business. Its founding coincided with the search by third-party payers for alternative and potentially less costly delivery settings. Because of its success in metropolitan Miami, Southeastern expanded services into Fort Lauderdale and West Palm Beach and then moved into other metropolitan areas in Florida and across the US Southeast. Southeastern also expanded services at each location to include occupational, speech, and rehabilitation therapies. The founders had sufficient personal resources to start Southeastern, 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 the founders' personal funds, forcing them to borrow heavily. Soon, although they still needed exter- nal capital to finance growth, their ability to borrow at reasonable rates was exhausted. Thus, in 2002, the founders incorporated Southeastern and in 2005, sold common stock to the public through an initial public offering. Today, the founders still retain a large but minority ownership position at Southeastern, and the Southeastern stock trades in the over-the-counter market. Foundation of ACHE, 2018. Reproduction without permission is prohibited. 105 Case 17: Southeastern Homecare 107 its operations and its corporate managerial processes. As a first step, the board directed the financial vice president (VP) to develop an estimate for Southeastern's cost of capital. The financial VP, in turn, directed South- eastern's treasurer, Clark Ruffin, to prepare and submit a cost-of-capital estimate in two weeks. He 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 Southeastern's 2017 financial statements (pre- sented in exhibit 17.1 in simplified form) and by obtaining some selected market data (presented in exhibit 17.2). Next, he assembled the following data. Long-Term Debt Southeastern's 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 $50, for a total of $1,050. The founders have an aversion to short-term debt, so such debt is used only to fund cyclical working capital needs. Southeastern's financial plan calls for the issue of 30-year bonds to meet long- term debt needs. Equity Southeastern's last dividend (DO) was $0.17, and its common stock now sells at a price of $5.25 per share. The company has 10 million common shares outstanding. In the past few years, Southeastern has averaged a 20 percent return on equity and has paid out about 50 percent of its net income as dividends. Southeastern's historical beta, as measured by several analysts who follow the stock, falls in the range of 1.3 to 1.5. Capital Structure Southeastern's federal-plus-state tax rate is 40 percent. Southeastern's target capital structure includes weights of 35 percent long-term debt and 65 percent common stock. I 100% + I 108 Cases in Healthcare Finance Operating Divisions About 60 percent of Southeastern's operating assets are used by the Healthcare Services division, and 40 percent by the Information Systems division. Management's best estimate of the Healthcare Services division's beta is 1.0. Following are the two divisions' investment opportunities for next year: Healthcare Services Division A new office in Naples A new office in Sarasota Information Systems Division A new healthcare record system Expanded billing software Estimated internal rate of return 9.3% 9.8% Estimated internal rate of return 12.2% 13.2% Clark has hired you as a consultant to develop Southeastern's 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. In addition to performing a standard analysis, you must address several concerns raised at the last board meeting about the cost-of-capital estimate. First, the board chair noted that the corporate cost-of-capital estimate is influenced by several factors, some of which are external to the business. atleast care 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. In addition to performing a standard analysis, you must address several concerns raised at the last board meeting about the cost-of-capital estimate. First, the board chair noted that the corporate cost-of-capital estimate is influenced by several factors, some of which are external to the business. She is particularly interested in the impact on the estimated corporate cost of capital of factors that cannot be influenced by managerial actions. Second, the divisional presidents questioned why a single cost of capital will be applied across the company, regardless of any divisional risk differ- ences. Clark has asked you to address this question by developing divisional costs of capital. Third, the founders alerted the group to the threat posed by home health care businesses started by not-for-profit hospitals, which have both cost (in the sense that they do not pay dividends) and tax advantages. To help assess this threat, Clark has asked you to estimate the cost of capital for an average not-for-profit hospital's home health care business, starting with the information in exhibit 17.3. 17 vuurwasten Tomrecare T09 Finally, one board director is worried about the difference between the target capital structure and the current structure as reported on the balance sheet. Clark wondered if this should be a matter for consideration. Balance Sheet $ 2.5 $ 1.1 1.0 EXHIBIT 17.1 Southeastern Homecare: 2017 Financial Statement Extracts (in Millions of Dollars) Cash and marketable securities Accounts receivable Inventory Current assets Net fixed assets 5.9 1.3 0.2 $ 9.7 Accounts payable Accruals Notes payable Current liabilities Long-term debt Common stock Total liabilities 41.9 $ 2.3 20.0 29.3 Total assets $51.6 $51.6 Income Statement $80.6 Net revenues Cash expenses Depreciation Taxable income Taxes Net income Dividends Additions to retained earnings 71.8 2.8 $ 6.0 2.4 $ 3.6 1.8 $ 1.8 EXHIBIT 17.2 Selected Market Data Expected Rate of Return on the Market Expected rate of return on the S&P 500 Index = 11.0% Required Rate of Return on Long-Term Debt of an Average Company Yield to maturity on A-rated long-term debt for a company with a beta of 1.0 = 70% Current Yield Curve on US Treasury Securities Yield 2.5% 3.0 3.3 3.5 Term to Maturity 3 months 6 months 9 months 1 year 5 years 10 years 15 years 20 years 25 years 30 years 4.0 4,5 4.8 5.0 5.1 5.2 EXHIBIT 17.3 Selected Not-for-Profit Hospital Data Average Long-Term Capital Structure 30 percent debt 70 percent equity (net assets) Average Cost of Debt Interest rate on A-rated tax-exempt bonds = 5.0% prime 5 / 10 100% + 1 0 0 SOUTHEASTERN HOMECARE WAS founded in 1992 in Miami, Florida, as a taxable partnership by Maria Gonzalez, MD; Ramon Garcia, RN; and Ron Sparks, LPT. Its purpose is to provide an at-home alternative to hospitals and ambulatory care facilities for basic healthcare services provided by physi- cians, registered 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.) Southeastern enjoyed enormous success from the first day of operations. Even its founders were surprised at how easy it was to establish and run the business. Its founding coincided with the search by third-party payers for alternative and potentially less costly delivery settings. Because of its success in metropolitan Miami, Southeastern expanded services into Fort Lauderdale and West Palm Beach and then moved into other metropolitan areas in Florida and across the US Southeast. Southeastern also expanded services at each location to include occupational, speech, and rehabilitation therapies. The founders had sufficient personal resources to start Southeastern, 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 the founders' personal funds, forcing them to borrow heavily. Soon, although they still needed exter- nal capital to finance growth, their ability to borrow at reasonable rates was exhausted. Thus, in 2002, the founders incorporated Southeastern and in 2005, sold common stock to the public through an initial public offering. Today, the founders still retain a large but minority ownership position at Southeastern, and the Southeastern stock trades in the over-the-counter market. Foundation of ACHE, 2018. Reproduction without permission is prohibited. 105 Case 17: Southeastern Homecare 107 its operations and its corporate managerial processes. As a first step, the board directed the financial vice president (VP) to develop an estimate for Southeastern's cost of capital. The financial VP, in turn, directed South- eastern's treasurer, Clark Ruffin, to prepare and submit a cost-of-capital estimate in two weeks. He 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 Southeastern's 2017 financial statements (pre- sented in exhibit 17.1 in simplified form) and by obtaining some selected market data (presented in exhibit 17.2). Next, he assembled the following data. Long-Term Debt Southeastern's 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 $50, for a total of $1,050. The founders have an aversion to short-term debt, so such debt is used only to fund cyclical working capital needs. Southeastern's financial plan calls for the issue of 30-year bonds to meet long- term debt needs. Equity Southeastern's last dividend (DO) was $0.17, and its common stock now sells at a price of $5.25 per share. The company has 10 million common shares outstanding. In the past few years, Southeastern has averaged a 20 percent return on equity and has paid out about 50 percent of its net income as dividends. Southeastern's historical beta, as measured by several analysts who follow the stock, falls in the range of 1.3 to 1.5. Capital Structure Southeastern's federal-plus-state tax rate is 40 percent. Southeastern's target capital structure includes weights of 35 percent long-term debt and 65 percent common stock. I 100% + I 108 Cases in Healthcare Finance Operating Divisions About 60 percent of Southeastern's operating assets are used by the Healthcare Services division, and 40 percent by the Information Systems division. Management's best estimate of the Healthcare Services division's beta is 1.0. Following are the two divisions' investment opportunities for next year: Healthcare Services Division A new office in Naples A new office in Sarasota Information Systems Division A new healthcare record system Expanded billing software Estimated internal rate of return 9.3% 9.8% Estimated internal rate of return 12.2% 13.2% Clark has hired you as a consultant to develop Southeastern's 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. In addition to performing a standard analysis, you must address several concerns raised at the last board meeting about the cost-of-capital estimate. First, the board chair noted that the corporate cost-of-capital estimate is influenced by several factors, some of which are external to the business. atleast care 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. In addition to performing a standard analysis, you must address several concerns raised at the last board meeting about the cost-of-capital estimate. First, the board chair noted that the corporate cost-of-capital estimate is influenced by several factors, some of which are external to the business. She is particularly interested in the impact on the estimated corporate cost of capital of factors that cannot be influenced by managerial actions. Second, the divisional presidents questioned why a single cost of capital will be applied across the company, regardless of any divisional risk differ- ences. Clark has asked you to address this question by developing divisional costs of capital. Third, the founders alerted the group to the threat posed by home health care businesses started by not-for-profit hospitals, which have both cost (in the sense that they do not pay dividends) and tax advantages. To help assess this threat, Clark has asked you to estimate the cost of capital for an average not-for-profit hospital's home health care business, starting with the information in exhibit 17.3. 17 vuurwasten Tomrecare T09 Finally, one board director is worried about the difference between the target capital structure and the current structure as reported on the balance sheet. Clark wondered if this should be a matter for consideration. Balance Sheet $ 2.5 $ 1.1 1.0 EXHIBIT 17.1 Southeastern Homecare: 2017 Financial Statement Extracts (in Millions of Dollars) Cash and marketable securities Accounts receivable Inventory Current assets Net fixed assets 5.9 1.3 0.2 $ 9.7 Accounts payable Accruals Notes payable Current liabilities Long-term debt Common stock Total liabilities 41.9 $ 2.3 20.0 29.3 Total assets $51.6 $51.6 Income Statement $80.6 Net revenues Cash expenses Depreciation Taxable income Taxes Net income Dividends Additions to retained earnings 71.8 2.8 $ 6.0 2.4 $ 3.6 1.8 $ 1.8 EXHIBIT 17.2 Selected Market Data Expected Rate of Return on the Market Expected rate of return on the S&P 500 Index = 11.0% Required Rate of Return on Long-Term Debt of an Average Company Yield to maturity on A-rated long-term debt for a company with a beta of 1.0 = 70% Current Yield Curve on US Treasury Securities Yield 2.5% 3.0 3.3 3.5 Term to Maturity 3 months 6 months 9 months 1 year 5 years 10 years 15 years 20 years 25 years 30 years 4.0 4,5 4.8 5.0 5.1 5.2 EXHIBIT 17.3 Selected Not-for-Profit Hospital Data Average Long-Term Capital Structure 30 percent debt 70 percent equity (net assets) Average Cost of Debt Interest rate on A-rated tax-exempt bonds = 5.0% prime