Golden State Home Health, Inc., is a large, California-based for-profit home hea

Question

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 firms last dividend (Do) was $1, and its current stock price is $10. The firms beta coefficient is 1.2; the rate of return on a 20 year T-bond 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 States target capital structure calls for 60 percent debt financing, the interest rate required on its new debt is 9 percent, and the firms tax rate is 30 percent.

a.What is the firms cost of equity estimate according to the DCF method?

b.What is the firms cost of equity estimate according to the CAPM?

c.On the basis of your answer to Parts a and b, what would be your final estimate for the firms cost of equity?

d.What is your estimate for the firms corporate cost of capital?

Explanation / Answer

a) Growth rate, g = 5%

D0 = $1; therefore D1 = $1 + 5% = $1.05

Current stock price, P0 = $10

Cost of equity = (D1/P0) + g = ($1.05/$10) + .05 = 15.5%

b) CAPM Model: Cost of equity = Risk-free rate + Beta (Return on market – Risk-free rate)

The rate on T-bonds is considered the risk-free rate (8%)

Beta = 1.2, Return on market = 14%

Cost of equity = 8% + 1.2 (14% - 8%) = 15.2%

c) My final estimate for the firm’s cost of equity would be 15.2%, as determined by the CAPM Model. This is because CAPM model is a better measure than the DCF measure as it considers the risk-free rate, the return expected in the market and the systematic risk as measured by beta. The DCF model does not consider the above mentioned factors but lays emphasis only on the expected future dividend and the growth rate. Hence, my final estimate for firm’s cost of equity is 15.2%.

d)

Corporate cost of capital = (Weight of debt x after-tax cost of debt) + (Weight of equity x cost of equity)

After-tax cost of debt = Before-tax cost of debt x (1 – T)

= 9% x (1-.30)

= 6.3%

Corporate cost of capital = (60% x 6.3%) + (40% x 15.2%)

= 3.78% + 6.08%

= 9.86%

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