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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 that this solution is merely a
starting point, and student work should be graded at least as much on the basis of thought processes,
assumptions used, creativity, and the ability to express ideas coherently, as on the resulting answers.Cases in
Healthcare Finance Case 16 Solution Case 16 - 3
1. 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?
Typically, the corporate cost of capital is used to make long-term capital structure and investment (capital
budgeting) decisions. Thus, the estimate should include the firm's long-term sources of funds: long-term debt,
preferred stock (if used), and common stock (or fund capital [net assets] for not-for-profit organizations). If a
business uses short-term interest-bearing debt as part of its permanent capital base, rather than a temporary
source of funds to finance seasonal or cyclical working capital needs, then its corporate cost of capital estimate
should include one or more short-term debt components. Non-interest-bearing debt, such as accounts payable
and accruals, generally is not included in corporate cost of capital estimates because (1) these funds are netted
out when determining investment needs (that is, changes in net working capital are included in capital
expenditures); and (2) spontaneous liabilities are not a managerial decision variable—in general, firms take as
much as they can get.
In most situations, the corporate cost of capital will be used to make decisions today (in reality, the near future)
that will affect future cash flows. In other words, capital will be raised in the future to invest in projects that
will be deemed acceptable by management. Thus, the relevant component costs are today's marginal costs
(which are estimates of the cost of capital raised in the future) rather than historical costs. In effect, today's
costs are used as the best predictor of the costs of raising capital in the near future.
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Optional Note
The question of tax implications often arises in cost of capital work. Generally, firms do not include any
financing effects in their capital budgeting cash flows, and hence the tax shield benefit of interest payments
must be incorporated into the cost of capital estimate. In other words, capital budgeting decisions focus on net
operating cash flows. Because the tax benefits associated with debt financing are not incorporated into the cash
flows, these benefits must be accounted for in the cost of capital. This leads to the (1 − T) term in the cost of
capital debt component for for-profit businesses. However, there are several other alternative cash flow
formats, and these require different specifications for the firm's corporate cost of capital. For example, if the
firm uses the cash flow to equityholders format, then the interest payments as well as the associated tax
benefits are incorporated into the cash flows, and the cost of capital is composed exclusively of the cost of
equity. Hence, there is no (1 − T) term.
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2. a. What is your estimate of Southern’s cost of debt?
Southern's 7.5 percent coupon bonds with 15 years to maturity are currently selling at $956.31. Thus the yield
to maturity (YTM) is 8.0 percent:
$956.31 = PV
$37.50 = Semiannual coupon payment.
30 = Number of semiannual periods to maturity.
$1,000 = Maturity value.
YTM/2 = 4.0%, so YTM = 8.0%.Case 16 Solution Cases in Healthcare Finance Case 16 - 4
The yield to maturity on this outstanding debt is a reasonable estimate of the firm’s pre-tax marginal cost of
debt. However, interest expenses are tax deductible for investor-owned firms, so the relevant component cost
of debt is the after-tax cost:
Component cost of debt = 8%(1 – T) = 8.0%(1 – 0.40) = 8.0%(0.60) = 4.8%.
b. Should flotation costs be included in the cost of debt calculation? Explain.
The actual before-tax cost of new debt will be somewhat higher than 8 percent because the firm will incur
flotation costs in selling the issue. However, many bond issues are placed directly with banks, insurance
companies, mutual funds, and the like (private placements), and such debt tends to have very low flotation
costs. Even public issues have relatively low flotation costs. Finally, the effective cost of flotation expenses is
reduced for taxable issuers because such costs can be amortized and expensed over the life of the issue. All in
all, the impact of flotation costs on the cost of debt estimate typically is so small that it is not material; so most
companies ignore such costs in their cost of debt estimates.
c. Should the stated (nominal) cost of debt or the effective annual rate be used? Explain.
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. Also, and
more important, while the stated cost understates the true cost, in capital budgeting analyses the cash flows
occur all during the year, but they are usually treated as end-of-year flows. Thus, the value of the cash flows is
also understated. In this situation, the use of a nominal cost estimate is more correct than an effective cost
estimate, because both are biased in the same direction (downward).
d. 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?
