Cost of Capital
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%)...
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