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CHAPTER 9 UHFM 6TH EDITION
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 9 — Cost of Capital PROBLEM 5 Morningside Nursing Home, a single not-for-profit facility, is estimating its corporate cost of capital. Its tax-exempt debt currently requires an interest rate of 6.2 percent and its target capital structure calls for 60 percent debt financing and 40 percent equity (fund capital) financing. The estimated costs of equity for selected investor-owned healthcare companies are given below: Glaxo Wellcome 15.0% Beverly Enterprises 16.4% HEALTHSOUTH 17.4% Humana 18.8% a. What is the best estimate for Morningside’s cost of equity? b. What is the firm’s corporate cost of capital? ANSWER PROBLEM 6
Golden State Home Health, Inc. is a large, California-based for-profit home health agency. Its dividends
are expected to grow at a constant rate of 5 percent per year into the foreseeable future. The firm’s last
dividend (D0) was $1, and its current stock price is $10. The firm’s beta coefficient is 1.2; the rate of
return on 20-year T-bonds currently is 8 percent; and the expected rate of return on the market, as
reported by a large financial services firm, is 14 percent. Golden State’s target capital structure calls
for 60 percent debt financing, the interest rate required on its new debt is 9 percent, and the firm’s tax
rate is 30 percent.
a. What is the firm’s cost of equity estimate according to the DCF method?
b. What is the cost of equity estimate according to the CAPM?
c. On the basis of your answers to Parts a and b, what would be your final estimate for the firm’s cost of
equity?
d. What is your estimate for the firm’s corporate cost of capital?
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
5/1/10
Chapter 9 — Cost of Capital
PROBLEM 1
Calculate the after-tax cost of debt for the Wallace Clinic, a for-profit healthcare provider, assuming that
the coupon rate set on its debt is 11 percent and its tax rate is
a. 0 percent
b. 20 percent
c. 40 percent
ANSWER
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 9 — Cost of Capital
PROBLEM 2
St. Vincent’s Hospital has a target capital structure of 35 percent debt and 65 percent equity. Its cost of
equity (fund capital) estimate is 13.5 percent and its cost of tax-exempt debt estimate is 7 percent. What
is the hospital’s corporate cost of capital?
ANSWER
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 9 — Cost of Capital
PROBLEM 3
Richmond Clinic has obtained the following estimates for its costs of debt and equity at various capital
structures:
Percent
debt
0%
20%
40%
60%
80%
After-Tax
Cost of
Debt
6.6%
7.8%
10.2%
14.0%
Cost of
Equity
16%
17%
19%
22%
27%
What is the firm’s optimal capital structure? (Hint: Calculate its corporate cost of capital at each
structure. Also, note that data on component costs at alternative capital structures are not reliable in
real-world situations.
ANSWER
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 9 — Cost of Capital
PROBLEM 4
Medical Associates is a large for-profit group practice. Its dividends are expected to grow at a constant
rate of 7 percent per year into the foreseeable future. The firm’s last dividend (D0) was $2, and its
current stock price is $23. The firm’s beta coefficient is 1.6; the rate of return on 20-year T-bonds is 9
percent; and the expected rate of return on the market, as reported by a large financial services firm, is
13 percent. The firm’s target capital structure calls for 50 percent debt financing, the interest rate
required on the business’s new debt is 10 percent, and its tax rate is 40 percent.
a. What is Medical Associate’s cost of equity estimate according to the DCF method?
b. What is the cost of equity estimate according to the CAPM?
c. On the basis of your answers to Parts a and b, what would be your final estimate for the firm’s cost of
equity?
d. What is your estimate for the firm’s corporate cost of capital?
ANSWER
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 9 — Cost of Capital
PROBLEM 5
Morningside Nursing Home, a single not-for-profit facility, is estimating its corporate cost of capital. Its
tax-exempt debt currently requires an interest rate of 6.2 percent and its target capital structure calls
for 60 percent debt financing and 40 percent equity (fund capital) financing. The estimated costs of
equity for selected investor-owned healthcare companies are given below:
Glaxo Wellcome
Beverly Enterprises
HEALTHSOUTH
Humana
15.0%
16.4%
17.4%
18.8%
a. What is the best estimate for Morningside’s cost of equity?
b. What is the firm’s corporate cost of capital?
ANSWER
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Chapter 9 — Cost of Capital
PROBLEM 6
Golden State Home Health, Inc. is a large, California-based for-profit home health agency. Its dividends
are expected to grow at a constant rate of 5 percent per year into the foreseeable future. The firm’s last
dividend (D0) was $1, and its current stock price is $10. The firm’s beta coefficient is 1.2; the rate of
return on 20-year T-bonds currently is 8 percent; and the expected rate of return on the market, as
reported by a large financial services firm, is 14 percent. Golden State’s target capital structure calls
for 60 percent debt financing, the interest rate required on its new debt is 9 percent, and the firm’s tax
rate is 30 percent.
a. What is the firm’s cost of equity estimate according to the DCF method?
b. What is the cost of equity estimate according to the CAPM?
c. On the basis of your answers to Parts a and b, what would be your final estimate for the firm’s cost of
equity?
d. What is your estimate for the firm’s corporate cost of capital?
ANSWER
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