Problem 1
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT | 2/6/14 | |||||||
Chapter 16 — Business Valuation, Mergers, and Acquisitions | ||||||||
PROBLEM 1 | ||||||||
Assume that you have been asked to place a value on the ownership position in Briarwood Hospital. Its | ||||||||
projected profit and loss statements and retention requirements are shown below (in millions): | ||||||||
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | ||||
Net revenues | $225.0 | $240.0 | $250.0 | $260.0 | $275.0 | |||
Cash expenses | $200.0 | $205.0 | $210.0 | $215.0 | $225.0 | |||
Depreciation | $11.0 | $12.0 | $13.0 | $14.0 | $15.0 | |||
Earnings before interest and taxes | $14.0 | $23.0 | $27.0 | $31.0 | $35.0 | |||
Interest | $8.0 | $9.0 | $9.0 | $10.0 | $10.0 | |||
Earnings before taxes | $6.0 | $14.0 | $18.0 | $21.0 | $25.0 | |||
Taxes (40 percent) | $2.4 | $5.6 | $7.2 | $8.4 | $10.0 | |||
Net profit | $3.6 | $8.4 | $10.8 | $12.6 | $15.0 | |||
Estimated retentions | $10.0 | $10.0 | $10.0 | $10.0 | $10.0 | |||
Briarwood’s cost of equity is 16 percent, its cost of debt is 10 percent, and its optimal capital structure is | ||||||||
40 percent debt and 60 percent equity. The best estimate for Briarwood’s long-term growth rate is 4 | ||||||||
percent. Furthermore, the hospital currently has $80 million in debt outstanding. | ||||||||
a. What is the equity value of the hospital using the Free Operating Cash Flow (FOCF) method? | ||||||||
b. Suppose that the expected long-term growth rate was 6 percent. What impact would this change have | ||||||||
on the equity value of the business according to the FOCF method? What if the growth rate were | ||||||||
only 2 percent? | ||||||||
c. What is the equity value of the hospital using the Free Cash Flow to Equityhloders (FCFE) method? | ||||||||
d. Suppose that the expected long-term growth rate was 6 percent. What impact would this change have | ||||||||
on the equity value of the business according to the FCFE method? What if the growth rate were | ||||||||
only 2 percent? | ||||||||
ANSWER |
Problem 2
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT | |||||||
Chapter 16 — Business Valuation, Mergers, and Acquisitions | |||||||
PROBLEM 2 | |||||||
Assume that you have been asked to place a value on the fund capital (equity) of BestHealth, a | |||||||
not-for-profit HMO. Its projected profit and loss statements and retention requirements are | |||||||
shown below (in millions): | |||||||
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |||
Net revenues | $50.0 | $52.0 | $54.0 | $57.0 | $60.0 | ||
Cash expenses | $45.0 | $46.0 | $47.0 | $48.0 | $49.0 | ||
Depreciation | $3.0 | $3.0 | $4.0 | $4.0 | $4.0 | ||
Interest | $1.5 | $1.5 | $2.0 | $2.0 | $2.5 | ||
Net profit | $0.5 | $1.5 | $1.0 | $3.0 | $4.5 | ||
Estimated retentions | $1.0 | $1.0 | $1.0 | $1.0 | $1.0 | ||
The cost of equity of similar for-profit HMO’s is 14 percent, while BestHealth’s cost of debt is 5 | |||||||
percent. Its current capital structure is 60 percent debt and 40 percent equity. The best estimate | |||||||
for BestHealth’s long-term growth rate is 5 percent. Furthermore, the HMO currently has | |||||||
$30 million in debt outstanding. | |||||||
a. What is the equity value of the HMO using the Free Operating Cash Flow (FOCF) method? | |||||||
b. Suppose that it was not necessary to retain any of the operating income in the business. What | |||||||
impact would this change have on the equity value according to the FOCF method? | |||||||
ANSWER |
Problem 3
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT | |||
Chapter 16 — Business Valuation, Mergers, and Acquisitions | |||
PROBLEM 3 | |||
Columbia Home Care Inc. is considering a merger with HCA Home Care Inc. HCA is a publicly | |||
traded company, and its current beta is 1.30. HCA has been barely profitable and had paid an average | |||
of only 20 percent in taxes during the last several years. In addition, it uses little debt, having a debt | |||
ratio of just 25 percent. If the acquisition were made, Columbia would operate HCA as a separate, | |||
wholly owned subsidiary. Columbia would pay taxes on a consolidated basis, and the tax rate would | |||
therefore increase to 35 percent. Columbia also would increase the debt capitalization in the HCA | |||
subsidiary to 40 percent of assets, which would increase its beta to 1.50. Columbia estimates that | |||
HCA, if acquired, would produce the following net cash flows to Columbia’s shareholders (in millions | |||
of dollars): | |||
Year | Free Cash Flows to Equityholders | ||
1 | $1.30 | ||
2 | $1.50 | ||
3 | $1.75 | ||
4 | $2.00 | ||
5 and beyond | Constant growth at 6% | ||
These cash flows include all acquisition effects. Columbia’s cost of equity is 14 percent, its beta is 1.0, | |||
and its cost of debt is 10 percent. The risk-free rate is 8 percent. | |||
a. What discount rate should be used to discount the estimated cash flow? (Hint: Use Columbia’s cost of | |||
equity to determine the market risk premium.) | |||
b. What is the dollar value of HCA to Columbia’s shareholders? | |||
ANSWER |
Problem 4
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT | ||
Chapter 16 — Business Valuation, Mergers, and Acquisitions | ||
PROBLEM 4 | ||
Hastings HMO is interested in acquiring Vandell, a smaller HMO in its service area. Vandell has | ||
1 million shares outstanding and a target capital structure consisting of 30 percent debt. Vandell’s | ||
debt interest rate is 8 percent. Assume that the risk-free rate of interest is 5 percent and the market | ||
risk premium is 6 percent. Both Vandell and Hastings face a 40 percent tax rate. | ||
Vandell’s Free Operating Cash Flow is $2 million per year and is expected to grow at a constant | ||
rate of 5 percent a year; its beta is 1.4. If Vandell has $10.82 million in debt, what is the current | ||
value of Vandell’s stock? What price per share should Hastings bid for each share of Vandell | ||
common stock? | ||
ANSWER |