Southern Healthcare and BestWell are for-profit HMOs that operate in Florida and

Question

Southern Healthcare and BestWell are for-profit HMOs that operate in Florida and Georgia. Currently,
both are identical in every respect except that Southern is unleveraged while BestWell has $10 million of
5 percent bonds. Both HMOs report an EBIT of $2 million and pay corporate tax at a rate of 40 percent. The
cost of equity to Southern is 10 percent. Assume that all of the MM assumptions hold.
a. What total value would MM estimate for each HMO?
b. What is the value of the equity of each HMO?
c. What is the required rate of return on equity for each HMO?
d. What is the corporate cost of capital for each HMO?

Explanation / Answer

a) Computing the total value of Southern Healthcare: Vu = [EBIT(1- Tc)] /Ru where Tc is the tax rate           Ru is the cost of capital.           Vu is the unlevered Vu = [$2,000,000 (1-0.40)] / 0.10      = $1,200,000 / 0.10      = $12,000,000 Therefor,e the total value of Southern Healthcare firm is $12,000,000 Computing the total value of Best Well : Vl = Vu + (Tc*D)     = $12,000,000 + (0.4 * $10,000,000)     = $12,000,000 + $4,000,000     = $16,000,000 Therefore, the total value of Best Well company is $16,000,000 b) The value of equity for Southern Healthcare is $12,000,000 The value of equity for Best Well is E = V - D Because the value of the firm is worth $16,000,000 and the total debt is $10,000,000, the equity is worth E = $16,000,000 - $10,000,000    = $6,000,000 c) Computing the cost of equity for Best Well: Re = Ru + (Ru - Rd) * (D/E) * (1-Tc)      = 0.10 + (0.10 - 0.05) * ($10,000,000 / $6,000,000) * (1-0.40)      = 0.10 +  0.05      = 0.15 or 15% d) Computing the Cost of capital for Southern Healthcare: WACC = (E/V) * Cost of equity            = ($12,000,000 / $12,000,000) * 0.1            = 0.1 or 10% Computing the cost of capital for Best Well firm: WACC = (E/V) * Cost of equity + (D/V) * Cost of debt * (1-TAx rate)            = ($6,000,000 / $16,000,000) * 0.15 + ($10,000,000 / $16,000,000) * 0.05 * (1-0.4)            = 0.05625 + 0.01875            = 0.075 or 7.5% Therefore, the WACC for Best Well firm is 7.5%

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