Background

Southeastern Homecare was initially a taxable partnership owned organization run by three partners, but later due to lack of capital and the rapid growth of the organization, the company was incorporated and the stocks were sold to the public. The company has two operating divisions: the Healthcare Services Division and the Information Systems Division. Both these divisions provide different services and operate individually. The Information Systems Division operates on a larger scale and competes with the market; it owns more business risk as compared to the other division. However, due to recent changes in the market and rising competition from the other home healthcare facilities and not-for-profits as well as reduced payments from the CMS has made the board of Southeastern Homecare to start developing their operating system by managing and analyzing the company’s cost of capital.

Thus, this case is focusses on estimating the cost of capital for Southeastern Homecare and also analyzes the several factors affecting it. It also allows estimating the divisional cost of capital for both of their operating divisions. In this case, the corporate cost of capital needs to be analyzed and hence, to estimate that, a company’s long-term source of funds (common stock, long-term debts and preferred stock) should be used. Since the corporate cost of capital is used to make decisions today, which will affect the future cash flows, the only acceptable costs are today’s marginal costs that are used. These marginal values are the estimates of the cost of capital that will be raised in future which will provide an accurate estimation of raising the capital in future.

Southeastern Homecare has 7.5 percent coupon bonds with 15 years to maturity are currently selling at $956.31 $956.31 = PV, $37.50 = Semiannual coupon payment, 30 = Number of semiannual periods to maturity, $1,000 = Maturity value. Cost of debt = before tax rate * (1 – marginal tax) = 8%(1 – T) = 8.0%(1 – 0.40) = 8.0%(0.60) = 4.8%.

Flotation costs are paid by the company that issues the new securities and includes expenses such as underwriting fees, legal fees and registration fees. The company will incur floatation since before tax cost of the new debt will be higher than 8%. It can be included in calculating the cost of debt but these costs are reduced for taxable issuers and therefore can be expensed over the life of the issue.

The 8 percent pre-tax estimate is the nominal cost of debt. Because the firm’s debt has semiannual coupons, its effective annual cost rate is 8.16 percent EAR = (1.04)2 – 1.0 = 1.0816 – 1.0 = 0.0816 = 8.16%.

Because the difference between nominal and effective costs usually is small, it is generally ignored. The yield to maturity on a 15-year bond is a true estimate of the cost of 30-year bond If the debt had not been recently traded, then other methods of estimating the cost of debt are by estimating the cost of new BBB rated issues of other firms. Retained earnings will deprive the shareholder’s opportunity to reinvest the dividends in stock or bonds. So the shareholders are given the same amount as they would have received as retained earnings through dividends and so in such case the company incurs a cost for retaining the earnings.

The cost of equity (using the CAPM) approach:

R (Re) = RF + [R (RM) ─ RF)] b

= 5.0% + (11.0% ─ 5.0%) 1.4

= 5.0% + 8.4% = 13.4%. DCF (Direct Cash Flow) = 13.6 DC+ RP = 12.3 The T- bills are less risky as compared to the T-bonds. T-bonds have a price risk premium to compensate investors for bearing price risk and hence can be a better proxy for the risk-free rate. Market risk premiums can be estimated either by using historical data or future estimates.

Discounted cash flow (DCF) cost of equity:

E (D1) D0 [1 + E (g)] = 13.6%. (Assuming that the growth rate is constant) (Assuming that Southeastern Homecare has a constant growth rate of 10%)

If Southeastern Home care’s historical 50 percent dividend payout is expected to continue into the future, then the Retention rate = 1 Payout rate = 1 − 0.50 = 0.50, and hence E (g) = 0.50(20%) = 10.0%. The return on equity on new investment will equal the firm’s current ROE, which implies that the return on equity will remain constant. The Southeastern’s cost of equity is 13.4% (CAPM approach) Southeastern’s corporate cost of capital (CCC) is about 10.1 percent: CCC = wdR (Rd) (1 – T) + weR (Re).

= 0.35(8.0%) (0.6) + 0.65(13.0%) = 1.68% + 8.45% = 10.13%, or about 10.1%. Southeastern’s overall corporate cost of capital, 10.1 percent, reflects the overall riskiness of the firm as seen by its investors. The Healthcare Services Division, which represents 60 percent of the firm’s assets, has an estimated beta of 1.0, Therefore, the Information Systems Division must have a beta of 2.0 (0.60(1.0) + 0.40x = 1.4

0.40x = 0.8 x = 2.0

Assuming the same corporate tax rate and debt cost for each division

Healthcare Services Division

R (Re) = RF + [R (RM) – RF)] b

= 5.0% + (11.0% – 5.0%) 1.0

= 5.0% + 6.0% = 11.0%.

CCC = wdR (Rd) (1 – T) + weR (Re)

= 0.35(8.0%) (0.6) + 0.65(11.0%) = 1.68% + 7.15% = 8.83, or about 8.8%.

Information Systems Division

R (Re) = RF + [R (RM) – RF)] b

= 5.0% + (11.0% ─ 5.0%) 2.0

= 5.0% + 12.0% = 17.0%.

CCC = wdR (Rd) (1 – T) + weR (Re)

= 0.35(8.0%) (0.6) + 0.65(17.0%) = 1.68% + 11.05% = 12.73, or about 12.7%.

Note that Southeastern’s aggregate cost of capital based on the divisional costs of capital is 10.4 percent: CCC = 0.60(8.8%) + 0.40(12.7%) = 10.4%,

If the divisions had significantly different debt capacities then the weights of debt and equity also could be adjusted for each division. However, this procedure leads to the problem of how capital structure changes affect the costs of debt and equity. Riskier projects within each division should be evaluated with a higher risk-adjusted cost of capital, and lower risk projects with a lower cost of capital than the overall divisional cost of capital. A cost of capital, whether corporate or divisional, typically is not a valid benchmark for projects in unrelated business lines.

Because the hospital division will be exclusively in home health care, the equity of a for-profit company in the same business line would have b = 1.0, which, when as we estimated in Question 8.a., produces a cost of equity estimate of 11.0 percent. If this is used as the cost of fund (equity) capital, the divisional cost of capital estimate for an average not-for-profit homecare division is 9.2 percent CCC = wdR (Rd) (1 – T) + weR (Re).

= 0.30(5.0%) (1.0) + 0.70(11.0%) = 1.50% + 7.70% = 9.2%

Thus, it appears that not-for-profit home health businesses do not have the advantage of lower capital costs when compared to their for-profit counterparts. Our confidence in the not-for-profit cost of capital estimate is low. The market value of debt = $20.0(0.95631) = $19.1 million

The market value of equity = $10 million ($5.25) = $52.5 million. Neither the current book value nor the market value weights are “right on” the firm’s target. However, Southeastern’s stock is selling well above book value, so its current market value structure is much closer to its 35%/65% debt/equity target capital structure (which is based on market values) than is its current book value structure.