Southeastern Homecare has two operating divisions: the Healthcare Services Divis

Question

Southeastern Homecare has two operating divisions: the Healthcare Services Division and the Information Systems Division. a. Estimate the divisional cost of capital for each of Southeastern’s divisions assuming that both divisions have the same optimal (target) capital structure. (Hint: Use the CAPM to produce a cost of equity for each division and assume the same corporate tax rate and debt cost for each division.) b. Southeastern’s divisions are each considering two investment opportunities for next year. In which of the projects should Southeastern invest? c. The divisional presidents have expressed concern that a single cost of capital will be applied across the company, regardless of any divisional risk differences. What would be the short-term and long-term consequences of Southeastern using a single cost of capital for both divisions? d. Is the divisional cost of capital applicable for all projects within that division? Explain. e. Suppose that one division has a greater capacity for debt financing than the other (perhaps due to higher asset value and profitability.) How could different target capital structures be incorporated into the divisional costs of capital?

CASE 18                 Student Version Copyright 2014 Health Administration Press 6/17/2016         SOUTHEASTERN HOMECARE                 Cost of Capital This case illustrates the cost of capital estimation for a business with two divisions that operate in diverse business lines. The spreadsheet calculates the cost of debt based on the yield to maturity and the yield to call of debt issues that are currently outstanding. It also calculates the cost of equity on the basis of three models: CAPM, DCF, and Debt Cost + Risk Premium. Students must use judgment when making the final estimates for the costs of debt and equity. These estimates must be entered into the lower part of the INPUT DATA section to calculate the corporate cost of capital. Divisional costs of capital can be estimated using the same part of this spreadsheet, but with the appropriate divisional input data. The model consists of a complete base case analysis—however, all values in the INPUT DATA section of the student version have been replaced with zeros. Thus, students must determine the appropriate input values and enter them into the model. These cells are colored red. When this is done, any error cells will be corrected and the base case solution will appear. Note that the model does not contain any risk analyses, so students will have to create their own if required by the case. Furthermore, students must create their own graphics (charts) as needed to present their results. INPUT DATA: KEY OUTPUT: Cost of Debt Input: Cost of Debt: Years to maturity 5     YTM 0.9% Annual coupon payment $0.08     YTC 2.0% Current price $956.31 Par value $1,000.00 Years to call 5 Call price $1,057.00 Cost of Equity Input: Cost of Equity:     CAPM Approach: Beta coefficient 1.4     CAPM 13.4% Risk-free rate 5.0% Required market return 11.0%     DCF Approach: Stock price $5.25     DCF 13.6% Last dividend paid $0.17 Constant growth rate 10.0%     Debt Cost Plus RP Approach: Risk premium 4.0%     DC+RP 4.9% Corporate Cost of Capital Input: Corporate Cost of Capital: Tax rate 40.0%     CCC 51.8% Weight of debt 35.0% Weight of equity 65.0% Final cost of debt estimate 30.0% Final cost of equity estimate 70.0%

Explanation / Answer

a) cost of debt should be yield to call of 2% since the Bonds are callable and the investors demands risk premiums for the call feature.cost of equity should be DCF as this gives realistic required return on equity as implied by the market is 13.6%.Thus cost of capital=.35*2%*(1-.40)+.65*13.6%=9.26%.

b)The investment opportunity that provides rate of return >than cost of capital of 9.26% should be invested in.

c)Single cost of capital can result in the unprofitable project for the division be accepted which in longer term can erode the profitability of the division.Divisional risk differences should be accounted for to find adequate cost of capital for each division and judge the projects to be invested in through the adjusted cost of capital.In shorter term may be profitable investment opportunities can be by passed or that unprofitable ventures are being pursued.

d)No,the divisional cost of capital is not applicable for all projects within that division,because the projects may have different risks inherent in them there could be real options and other risks that could inflate the cost of capital for that particular project therefore this calls for different cost of capitals for different projects.

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