Southeastern Homecare Cost of Capital: Balance sheet (millions of dollars Cash a
ID: 2710831 • Letter: S
Question
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. Southern’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 one year’s 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 company’s financial plan calls for the issue of 30-year bonds to meet long-term debt needs.
3. Southern’s federal-plus-state tax rate is 40 percent.
4. Southern’s last dividend (D0) was $0.18, and most analysts predict the company’s dividend to grow at a relatively constant annual rate somewhere in the range of 8 percent to 12 percent. Southern’s 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. Southern’s 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) company’s long-term debt is 7 percent.
10. Southern’s 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 firm’s cost of equity: the bond yield plus risk-premium method. Here, a risk premium is added to the firm’s 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 firm’s cost of equity and its cost of debt.
12. About 60 percent of Southern’s operating assets are used by the Healthcare Services Division, and 40 percent are used by the Information Systems Division. Management’s best estimate of the beta of its Healthcare Services Division is 1.0.
Assume that Clark has hired you as a consultant to develop Southern’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 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 capital’s 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 hospital’s 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 Southern’s directors has expressed concern over the difference between the company’s target capital structure and the current structure as reported on the balance sheet. Clark wondered if this should be a matter of concern.
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
Explanation / Answer
Southeastern Homecare Coupon rate of long term bonds 7.50% semi-annual Remaining time to maturity 15 years Par Value 1000 Period for callable option 5 years Call Price 1075 Current Price 956.31 Coupon amount =1000*7.5%*0.5 37.5 ytm =37.5 * (1-(1/(1+r/2)^30)/r) + 1000/(1+r/2)^30 Let r be equal to 8.005%, then price = 956.3509 As the price is very close to the price at which the bond is currently selling the YTM is 8.005% per annum In case the bond is called in 5 years then ytm = =37.5 * (1-(1/(1+r/2)^10)/r) + 1000/(1+r/2)^10 At r = 5.75% or a semi annual rate of 0.02875%, bond price = 1075.118 As the price is very close to the callable price the ytm to call is 5.75% Calculation of cost of equity/required rate of return on equity Cost of Equity estimated based on dividends last dividend 0.18 average estimated growth rate of dividend =(8%+10%)/2 10% Current share price 5.25 Required rate of return = (0.18 * 1.10)/5.25 + 0.10 = 0.137714 or 13.77% Cost of equity estimated based on CAPM Expected rate of return on S&P500 index 11% Range of Beta = 1.3-1.5 Average Beta 1.4 Given that the founders of the company are averse to risk and favour 30 year bonds, the risk free rate can be taken as that of 30 year t-bond risk-free rate 5.20% Expected rate of return on equity =rf + Beta (rm-rf) = 5.2% + 1.4 * (11%-5.2%) 0.1332 or 13.32% Cost of Equity based on bond-yield + risk premium Average Beta 1.4 required return on A-rated bond (Beta=1.0) 7% Required return on Company's bonds = beta * return on A-rated bonds 0.098 or 9.80% Risk Premium = cost of equity - pre-tax cost of debt = 20 - 8.01 11.99 Cost of Equity = bond yield + risk premium = 9.80%+11.99% 21.7900% Calculation of weights of equity and debt Market Price of stock 5.25 Total number of Shares outstanding 10000000 Market Value of Equity 52500000 Market Value of Debt 20000000 Weight of equity for WACC calculation = market value of equity/(market value of equity+market value of debt) 0.724138 Weight of debt for WACC calculation = market value of debt/(market value of equity+market value of debt) 0.275862 Tax rate 40% Weighted Average Cost of Capital = weight of equity * cost of equity + weight of debt * cost of debt * (1-tax rate) The estimates available for cost of equity and cost of debt are as follows Cost of Debt - ytm 8.01% Cost of debt - ytm on callable option 5.75% Cost of debt - based on bond yield 9.80% Cost of Equity - Dividends 13.77% Cost of Equity - CAPM 13.32% Cost of equity based on bond yield+risk premium 21.79% Current cost of equity 20% Calculation of weighted average cost of capital WACC based ytm and cost of equity -dividends = 0.724138 * 13.77% + 0.275862 * 8.01% * (1-0.40) 0.112972 or 11.30% WACC based on callable ytm + capm = 0.724138 * 13.32% + 0.275862 * 5.75% * (1-0.40) 0.105972 or 10.60% WACC based on bond yield + bond yield+rp = 0.724138 * 21.79% + 0.275862 * 9.80% * (1-0.40) 0.17401 or 17.40% WACC basedon current cost of capital and ytm = 0.724138 * 20% + 0.275862 * 8.01% * (1-0.40) 0.158086 or 15.81% Target weights of debt and equity for firm debt 0.35 equity 0.65 Target WACC based on current cost of equity, ytm =0.65*20%+0.35*8.01%*(1-0.40) 0.146821 or 14.68% Given the aversion of the founders of the company to the short term debt, we may expect the callable option may not be exercised. Hence WACC can be taken as 15.81% Cost of equity for Healthcare Division Beta 1 Market return 11% risk-free rate 5.20% Based on CAPM, cost of equity = 5.2% + 1 *(11%-5.2%) 0.11 or 11% Porportion of Healthcare division in total op assets 60% Assuming the current debt and equity calculated above hold good for Healthcare division, the WACC for Healthcare division would be WACC for Healthcare Division = 0.724138 * 11% + 0.275862 * 8.01% * (1-0.40) 0.092913 or 9.29% WACC for Information Systems Division =(10.6% - 0.6 * 9.29%)/0.40 0.12565 or 12.57% WACC for not-for-profit Hospital =0.70 * 20% +0.3 * 5% 0.155 or 15.50% Compared to the WACC of not of not-for-profit hospital the current WACC of 15.81% for the firm compares favourably Given the target WACC of 14.68% vis-à-vis the current WACC of 15.81%, the company may take steps to issue additional bonds to increase proportion of debt in total capital structure to bring it close to target capital stucture.
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