Assume that you have been asked to place a value on the fund capital (equity) of
ID: 2644227 • Letter: A
Question
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? 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?Explanation / Answer
a. Equity Value
WACC = (Cost of Debt * Weight of Debt) + (Cos
Total
167.26
Value of Equity = Value of Firm - Value of Debt
= 167.26-20
= $137.26
b. If it was not necessary to retain any operating income in the business then growth rate would become equal to zero.
Year 1st 2nd 3rd 4th 5th Net Profit 0.5 1.5 1 3 4.5 Add: Interest 1.5 1.5 2 2 2.5 Add: Depreciation 3 3 4 4 4 Free Operating Cash Flow 5 6 7 9 11 Value at the end of 5th Year =11/(cost of capital - growth) =11/(0.10-0.05) =220 Rate (WACC) 1.086 =1.086^2 =1.086^3 =1.086^4 =1.086^5 1.09 1.18 1.28 1.39 1.51 Present Value 4.60 5.09 5.47 6.47 145.64Total
167.26
Value of Equity = Value of Firm - Value of Debt
= 167.26-20
= $137.26