Assume that you have been asked to place a value on the ownership position in Br
ID: 2669402 • Letter: A
Question
Assume that you have been asked to place a value on the ownership position in Briarwood Hospital. Itsprojected 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?
Explanation / Answer
Critical items are EBIT, Depreciation, After Tax Interest Expense and Retentions. Growth rate into perpetuity of 4% and Weighted Avg. Cost of Capital are also important. WACC is (.4)(.1)+(.6)(.16). This represents a 40% debt and 60% equity mix with costs of each of 10% and 16%, respectively. Other items are irrelevant. NOPAT=EBIT+ Depreciation-Retention-Interest Expense+Tax Benefit of Interest Expense. You have to take Cash flow in each year (NOPAT) and divide by 1.136 in the first year, 1.136 squared in the second year, 1.136 cubed in year 3, 1.136 to the fourth power in the fourth year and 1.136 to the fifth power in the fifth year. Year 1 Year 2 Year 3 Year 4 Year 5 EBIT 14 23 27 31 35 Depr. 11 12 13 14 15 Retention (10) (10) (10) (10) (10) Int. Exp. (8) (9) (9) (10) (10) Tax Adj. 3.2 3.6 3.6 4.0 4.0 NOPAT 10.2 19.6 24.6 29 34 Disc. CF 8.9789 15.188 16.7803 17.4134 17.9716 The Tax Adjustment is 40% of the Interest Expense, and since it is a benefit to cash flow, you add it back. Then get terminal value in Year 5, which is the final cash flow, growing at 4% into perpetuity and discounted back at 13.6% using the formula as follows: 34/(.136-.04)=354.1667. Discount this back another 5 years (to get you back to today's discounted PV) at 13.6% to get the value of the "into perpetuity" part, which is:(NNN) NNN-NNNN Add up the 6 cash flows and subtract the debt outstanding to get your answer. Add up the 7 cash flows, minus the 80mm debt: 8.9789+15.188+1637803+17.4134+17.9716+187.2044-80=183.5366 For the second part, with the growth rates at 2% and 6%, the first 5 cash flows are the same, but the terminal value differs. For a 6% growth rate, you use 6% instead of 4% in your terminal value calculation, then discount back at 13.6% for 5 years to get you to today's PV. 34/(.136-.06)=447.3684, discounted back to today is(NNN) NNN-NNNN Add up the 7 cash flows: 8.9789+15.188+1637803+17.4134+17.9716+236.4687-80=232.8009 For a 2% growth rate, you use 2% instead of 4% in your terminal value calculation, then discount back at 13.6% for 5 years to get you to today's PV. 34/(.136-.02)=293.1034, discounted back to today is(NNN) NNN-NNNN Add up the 7 cash flows: 8.9789+15.188+1637803+17.4134+17.9716+154.9278-80=151.26