UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT Chapter 16 -- Business Valuation,

Question

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

Explanation / Answer

Discount rate should be the required rate of return as per CAPM model.

              Required Return = Rf + Beta*(Rm – Rf)

8% + 1.5*(14% - 8%) = 17%

Terminal Value of Free Cash Flow to Equity holders:
=> [$2.00*(1+0.06)] / [0.17 – 0.06] = $19.27

Present Value of Terminal Value = $19.27 / (1.17)5 = $8.79
PV of cash flow in Year 1 = $1.30/(1.17)1 = $1.11
PV of cash flow in Year 2 = $1.50/(1.17)2 = $1.10

PV of cash flow in Year 1 = $1.75/(1.17)3 = $1.09

PV of cash flow in Year 1 = $2.00/(1.17)4 = $1.07

So, the dollar value = $1.11 + $1.10 + $1.09 + $1.07 + $8.79 = $13.16

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