Southern Healthcare and BestWe
| Southern Healthcare and BestWell are for-profit HMOs thatoperate in Florida and Georgia. Currently, | |||||||
| both are identical in every respect except that Southern isunleveraged while BestWell has $10 million | |||||||
| of5 percent bonds. Both HMOs report an EBIT of $2 million and paycorporate tax at a rate of 30 | |||||||
| percent. The cost of equity to Southern is 10 percent.Assume that all of the MM assumptions hold. | |||||||
| a.What total value would MM estimate for each HMO? | |||||||
| b.What is the value of the equity of each HMO? | |||||||
| c.What is the required rate of return on equity for eachHMO? | |||||||
| d.What is the corporate cost of capital for each HMO? | |||||||
Answer:
a)
Total Value of Southern Healthcare = EBIT(1-tax rate) / Requiredreturn on equity
Here EBIT = $2 million
Tax rate = 30%
Required rate of return on equity = 10%
= $2 million(1-30%) / 10%
= $1.4 million / 10%
=$14 million
Total Value of Bestwell = Total Value of Southern Healthcare +PV of interest tax shield
PV of interest tax shield = Total debt x Tax rate
= $10 million x 30%
= $ 3 million
Thus Total Value of Bestwell = 14 million + 3 million
= $ 17 million
b) Value of equity of Southern Healthcare = Total Value ofSouthern Healthcare = $14 Million
Value of equity of bestwell = Total Value of Bestwell – TotalDebt
= $17 million – 10 million
= $ 7 million
c) Required rate of return on equity for Southern Healthcare =10%
Required rate of return on equity for bestwell = Ru +[(Ru – Rd) x(D/E) x (1 – tax rate)]
Ru = Cost of equity of unlevered firm = 10%
Rd = Interest rate = 5%
D = Total value of Debt = $10 million
E = Total value of equity =$ 7 million
Tax rate = 30%
Thus Required rate of return on equity for bestwell = 10% +[(10%-5%) x (10/7) x (1-0.3)]
= 10% + [ 5% x 1.4286 x 0.7]
= 10% + 5%
= 15%
d) Cost of capital for Southern Healthcare = 10%
Cost of capital for Bestwell = [Cost of equity x E/(D+E) ] +[Interest rate(1-tax rate) x D/(D+E) ]
Cost of equity = 15%
Interest rate = 5%
D = Total value of Debt = $10 million
E = Total value of equity =$ 7 million
Tax rate = 30%
Cost of capital for Bestwell = [15% x 7/(7+10)] + [5%(1-0.3) x10/(7+10)]
=[15% x 7/17] + [3.5% x 10/17]
= 6.18% + 2.06%
= 8.24%
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