PROBLEM 1
St. Vincent's Hospital has a target capital structure of 35 percent debt and 65 percent equity. Its cost of equity (fund capital) estimate is 13.5 percent and its cost of tax-exempt debt estimate is 7 percent. What is the hospital's corporate cost of capital?
PROBLEM 2
Richmond Clinic has obtained the following estimates for its costs of debt and equity at various capital structures:
After-Tax |
| Percent Debt |
Cost of Debt |
Cost of Equity |
| 0% |
|
16% |
| 20% |
6.6% |
17% |
| 40% |
7.8% |
19% |
| 60% |
10.2% |
22% |
| 80% |
14.0% |
27% |
What is the firm's optimal capital structure? (Hint: Calculate its corporate cost of capital at each structure. Also, note that data on component costs at alternative capital structures are not reliable in real-world situations.)
PROBLEM 3
Morningside Nursing Home, a single not-for-profit facility, is estimating its corporate cost of capital. Its tax-exempt debt currently requires an interest rate of 6.2 percent, and its target capital structure calls for 60 percent debt financing and 40 percent equity (fund capital) financing. The estimated costs of equity for selected investor-owned healthcare companies are given below:
| Glaxo Wellcome |
15.0% |
| Beverly Enterprises |
16.4% |
| HEALTHSOUTH |
17.4% |
| Humana |
18.8% |
a. What is the best estimate for Morningside's cost of equity?
b. What is the firm's corporate cost of capital?
PROBLEM 4
A few years ago, the Value Line Investment Survey reported the following market betas for the stocks of selected healthcare providers:
| Company |
Beta |
| Quorum Health Group |
0.90 |
| Beverly Enterprises |
1.20 |
| HEALTHSOUTH Corporation |
1.45 |
| United Healthcare |
1.70 |
At the time these betas were developed, reasonable estimates for the risk-free rate, RF, and the required rate of return on the market, R(Rm), were 6.5 percent and 13.5 percent, respectively.
a. What are the required rates of return on the four stocks?
b. Why do their required rates of return differ?
c. Suppose that a person is planning to invest in only one stock rather than hold a well-diversified stock portfolio. Are the required rates of return calculated above applicable to the investment? Explain your answer.
PROBLEM 5
Consider the project contained in Problem 7 in Chapter 11 (California Health Center).
a. Perform a sensitivity analysis to see how NPV is affected by changes in the number of procedures per day, average collection amount, and salvage value. Remember supplies vary with number of procedures.
b. Conduct a scenario analysis. Suppose that the hospital's staff concluded that the three most uncertain variables were number of procedures per day, average collection amount, and the equipment's salvage value. Furthermore, the following data were developed:
Scenario |
Probability |
Number ofProcedures |
AverageCollection |
EquipmentSalvageValue |
| Worst |
0.25 |
10 |
$60 |
$100,000 |
| Most likely |
0.50 |
15 |
$80 |
$200,000 |
| Best |
0.25 |
20 |
$100 |
$300,000 |
|
c. Finally, assume that California Health Center's average project has a coefficient of variation of NPV in the range of 1.0 - 2.0. (Hint: Coefficient of variation is defined as the standard deviation of NPV divided by the expected NPV.) The hospital adjusts for risk by adding or subtracting 3 percentage points to its 10 percent corporate cost of capital. After adjusting for differential risk, is the project still profitable?
d. What type of risk was measured and accounted for in Parts b. and c.? Should this be of concern to the hospital's managers?
PROBLEM 6
Allied Managed Care Company is evaluating two different computer systems for handling provider claims. There are no incremental revenues attached to the projects, so the decision will be made on the basis of the present value of costs. Allied's corporate cost of capital is 10 percent. Here are the net cash flow estimates in thousands of dollars:
| Year |
System X |
System Y |
| 0 |
-$500 |
-$1,000 |
| 1 |
-$500 |
-$300 |
| 2 |
-$500 |
-$300 |
| 3 |
-$500 |
-$300 |
a. Assume initially that the systems both have average risk. Which one should be chosen?
b. Assume that System X is judged to have high risk. Allied accounts for differential risk by adjusting its corporate cost of capital up or down by 2 percentage points. Which system should be chosen?
PROBLEM 7
Michigan Home Health is considering opening an office in a new market. The organization has identified the number of home visits, revenue per home visit, and the level of fixed costs of the new office as being the major sources of uncertainty in the investment decision. To get a
better understanding of the sensitivity of the new office NPV to these variables, the following data have been assembled:
| Change from base case |
NPV |
| Number of home visits |
Revenue per home visit |
Level of fixed costs |
| -30% |
-$814 |
-$57 |
$82 |
| -20% |
-$515 |
-$11 |
$82 |
| -10% |
-$216 |
$36 |
$82 |
| 0% |
$82 |
$82 |
$82 |
| 10% |
$381 |
$129 |
$82 |
| 20% |
$680 |
$176 |
$82 |
| 30% |
$979 |
$222 |
$82 |
Construct a graph to show the sensitivity of the new office NPV to each variable.