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- What specific items of capital should be included in a corporate cost of capital estimate? Should historical (embedded) or new (marginal) values be used? Why?
- Estimate of Southern's cost of debt:
- What is your estimate of Southern’s cost of debt?
- Should flotation costs be included in the cost of debt calculation? Explain.
- Should the stated (nominal) cost of debt or the effective annual rate be used? Explain.
- Any new long-term debt issued by the company will likely have a 30-year maturity. How

valid is an estimate of the cost of debt based on 15-year bonds? If the estimate is not valid,

how might it be adjusted to remove any bias? - Suppose the company’s outstanding debt had not been recently traded; what other

methods could be used to estimate the cost of debt?

- Cost associated with retained earnings:
- Why is there a cost associated with retained earnings?
- What is the company’s estimated cost of equity using the CAPM approach?
- Why is the T-bond rate used to proxy the risk-free rate rather than the T-bill rate?
- How do historical betas, adjusted historical betas, and fundamental betas differ?
- How can the market risk premium be estimated?

- Discounted cash flow:
- Use the discounted cash flow (DCF) method to obtain a cost of equity estimate.
- The firm, over the last few years, has had a 20 percent average return on equity (ROE) and

has paid out about 50 percent of its net income as dividends. Under what conditions could

this information be used to help estimate the Southern's expected future dividend growth

rate?

- Use the debt cost (bond yield) plus risk premium method to estimate the cost of equity.
- What is your final estimate for Southern’s cost of equity? Explain your answer.
- What is your estimate for Southern’s corporate cost of capital?

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SOUTHERN HOMECARE

Cost of Capital

Case Information

This case is no directed, in that it does not contain a specific list of questions that students must answer. Rather, the case contains general guidance or concerns expressed by various parties that students should consider when developing their solutions. If you, as the instructor, want to convert this case to a directed case, and hence provide your students with very specific guidance questions, you can make available the applicable questions for this case contained in the Case Questions section of the online material for instructors.

Purpose

This case focuses on the estimation of the cost of capital for a business. There is minimal quantitative analysis required, but there are a significant number of conceptual issues that are addressed in the case.

Complexity

The calculations are not complex, but many of the issues merit a great deal of discussion and require a sound understanding of cost of capital principles.

Model Description

The model takes much of the busywork out of the case, so it enables students to spend more time on interpretation and evaluation. Like most case models, the student and instructor versions differ only in regards to the input data. The instructor’s version contains the complete base case inputs, while these inputs are zeroed out in the student version of the model.

The model uses market data relevant to both the business’s debt and equity as inputs to estimate the costs of debt and equity. Both YTM and YTC costs of debt are estimated, while the cost of equity is estimated using the CAPM, DCF, and Debt cost + Risk premium methods. Note that students must use judgment regarding which component cost estimates should be used in the corporate cost of capital estimate, so the component cost estimates (along with the correct weights) must be entered separately in Input Data section of the model

The model's (instructor version) Input Data and Key Output sections are shown on the next page:Case 16 Solution Cases in Healthcare Finance Case 16 - 2

INPUT DATA: KEY OUTPUT: Cost of Debt Input: Cost of debt (YTM)8.0% Cost of debt (YTC)9.8%Years to maturity15 Cost of equity (CAPM)13.4%Annual coupon payment$75.00 Cost equity (DCF)13.8%Current price$956.31 Cost equity (DC+RP)12.0%Par value$1,000.00Years to call5 CCC10.1%Call price$1,075.00 Cost of Equity Input: CAPM Approach:Beta coefficient1.4Risk-free rate5.0%Required market return11.0% DCF Approach:Stock price$5.25Last dividend paid$0.18Constant growth rate10.0% Debt Cost Plus RP Approach:Risk premium4.0% Corporate Cost of Capital Input:Tax rate40.0%Weight of debt35.0%Weight of equity65.0%Final cost of debt estimate8.0%Final cost of equity estimate13.0%These component cost inputs (not the output above) are used to estimate the corporate cost of capital.

Case Solution

Because the case is nondirected, there is ample opportunity for students to be creative in their solution approaches. Thus, it is impossible to provide a single solution here that is applicable to every student's work. As a starting point in evaluating students' solutions, we provide a solution that is based on the questions contained in online Case Questions section. It is important, however, to recognize th...

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