A large, for-profit home healthcare corporation has dividends expected to grow a

Question

A large, for-profit home healthcare corporation has dividends expected to grow at a constant rate of 5 percent per year into the foreseeable future. The firm’s last dividend (D0) was $1, and its current stock price is $10. The firm’s beta coefficient is 1.2; the rate of return on 20-year T-bonds currently is 8%; and the expected rate of return on the market, as reported by a large financial services firm is 14%. The corporation’s target capital structure calls for 60% debt financing, the interest rate required on its new debt is 9%, and the firm’s tax rate is 30%.

What is the firm’s cost of equity estimate according to the DCF method?

What is the cost of equity estimate according to the CAPM?

Based on your answers to (a) and (b), what would be your final estimate for the firm’s cost of equity?

What is your estimate for the firm’s corporate cost of capital?

Explanation / Answer

Answer: Calculation of the firm’s cost of equity estimate according to the DCF method:

Po=D1/Ke-g

Ke=D1/P0 +g

$10=$1(1.05)/(Ke-0.05)

10 Ke-0.5=$1.05

Ke=15.5%

Answer: Calculation of the cost of equity estimate according to the CAPM:

Ke=Rf+Beta[Erm-Rf]

=8%+1.2[14%-8%]

=15.2%

Answer: The final estimate for the cost of equity would simply be the average of the values found using the above two methods.

DCF=15.5%

CAPM=15.2%

Average=(15.5%+15.2%)/2=15.35%

Answer: Calculation of the firm’s corporate cost of capital:

WACC=Ke*We+Kd*Wd

=15.35%*0.40+0.60*(9%(1-0.30))

=6.14%+3.78%

=9.92%

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