chapter 16 problems

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UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT 5/1/10 Chapter 16 -- Business Valuation, Mergers, and Acquisitions PROBLEM 1 Assume that you have been asked to place a value on the ownership position in Briarwood Hospital. 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 $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? ANSWER

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UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT 5/1/10

Chapter 16 -- Business Valuation, Mergers, and Acquisitions

PROBLEM 1Assume 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 5Net revenues $225.0 $240.0 $250.0 $260.0 $275.0Cash expenses $200.0 $205.0 $210.0 $215.0 $225.0Depreciation $11.0 $12.0 $13.0 $14.0 $15.0 Earnings before interest and taxes $14.0 $23.0 $27.0 $31.0 $35.0Interest $8.0 $9.0 $9.0 $10.0 $10.0 Earnings before taxes $6.0 $14.0 $18.0 $21.0 $25.0Taxes (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 is40 percent debt and 60 percent equity. The best estimate for Briarwood's long-term growth rate is 4percent. 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?

ANSWER

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT

Chapter 16 -- Business Valuation, Mergers, and Acquisitions

PROBLEM 2Assume that you have been asked to place a value on the fund capital (equity) of BestHealth, anot-for-profit HMO. Its projected profit and loss statements and retention requirements areshown below (in millions):

Year 1 Year 2 Year 3 Year 4 Year 5Net revenues $50.0 $52.0 $54.0 $57.0 $60.0Cash expenses $45.0 $46.0 $47.0 $48.0 $49.0Depreciation $3.0 $3.0 $4.0 $4.0 $4.0Interest $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 5percent. Its current capital structure is 60 percent debt and 40 percent equity. The best estimatefor 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?

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT

Chapter 16 -- Business Valuation, Mergers, and Acquisitions

PROBLEM 3Columbia Home Care Inc. is considering a merger with HCA Home Care Inc. HCA is a publiclytraded company, and its current beta is 1.30. HCA has been barely profitable and had paid an averageof only 20 percent in taxes during the last several years. In addition, it uses little debt, having a debtratio 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 wouldtherefore increase to 35 percent. Columbia also would increase the debt capitalization in the HCAsubsidiary to 40 percent of assets, which would increase its beta to 1.50. Columbia estimates thatHCA, if acquired, would produce the following net cash flows to Columbia's shareholders (in millionsof dollars):

Year Free Cash Flows to Equityholders1 $1.302 $1.503 $1.754 $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

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT

Chapter 16 -- Business Valuation, Mergers, and Acquisitions

PROBLEM 4Hastings HMO is interested in acquiring Vandell, a smaller HMO in its service area. Vandell has1 million shares outstanding and a target capital structure consisting of 30 percent debt. Vandell'sdebt interest rate is 8 percent. Assume that the risk-free rate of interest is 5 percent and the marketrisk premium is 6 percent. Both Vandell and Hastings face a 40 percent tax rate.

Vandell's Free Operating Cash Flow is $2 million per year and is expected to grow at a constantrate of 5 percent a year; its beta is 1.4. If Vandell has $10.82 million in debt, what is the currentvalue of Vandell's stock? What price per share should Hastings bid for each share of Vandellcommon stock?

ANSWER