11.2 Twin Oaks Health Center has a bond issue outstanding with a coupon rate of 7 percent and four years remaining until maturity. The par value of the bond is $1000, and the bond pays interest annually.
a. Determine the current value of the bond if present market conditions justify a 14 percent required rate of return.
b. Now suppose Twin Oaks’ four-year bond had semiannual coupon payments. What would be its current value? (Assume a 7 percent semiannual required rate of return. However, the actual rate would be slightly less than 7 percent because a semiannual coupon bond is slightly less risky than an annual coupon bond.)
c. Assume that Twin Oaks’ four-year bond had a semiannual coupon but 20 years remaining to maturity. What is the current value under these conditions? (Again, assume a 7 percent semiannual required rate of return, although the actual rate would probably be greater than 7 percent because of increased price risk.)
12.3 A broker offers to sell you shares of Bay Area Healthcare, which just paid a dividend of $2 per share.
The dividend is expected to grow at a constant rate of 5 percent per year. The stock’s required rate of return is 12 percent.
a. What is the expected dollar dividend over the next three years?
b. What is the current value of the stock and the expected stock price at the end of each of the next three years?
c.What is the expected dividend yield and capital gains yield for each of the next three years?
d. what is the expected total return for each of the next three years?
e. how does the expected total return compare with the required rate of return on the stock? does this make sense? explain your answer.
California Clinics, an investor-owned chain of ambulatory are clinics, just paid a dividend of $2 per share. The firms dividend is expected grow at a constant rate of 5% per year and investors required a 15% rate of return on the stock.
a). what is the stock value?
b). Suppose the riskiness of the stock decreases, which causes the required rate of return to fall to 13%. Under conditions, what is the stock’s value?
c. Return to the original 15% required rate of return and assume a dividend growth rate estimate increase to 7% per year, what is the stock value?
Seattle Health Plans currently uses zero-debt financing. Its operating income (EBIT) is $1 million, and it pays taxes at a 40 percent rate. It has $5 million in assets and, because it is all-equity financed, $5 million in equity.
Suppose the firm is considering replacing half of its equity financing with debt financing bearing an interest rate of 8 percent.
a.) What impact would the new capital structure have on the firm’s net income, total dollar return to investors, and ROE?
b.) Redo the analysis, but now assume that the debt financing would cost 15 percent.
c.) Return to the initial 8 percent interest rate. Now. Assume that EBIT could be as low as $500,000 (with probability of 20 percent) or as high as $1.5 million (with a probability of 20 percent). There remains a 60 percent chance that EBIT would be $1 million. Redo the analysis for each level of EBIT, and find the expected values for the firm’s net income, total dollar return to investors, and ROE. What lesson about capital structure and risk does this illustration provide?
d.) Repeat the analysis required for part a, but now assume that Seattle Health Plans is not for-profit corporation and pays no taxes. Compare the results with those obtained in Part a.
Golden State Home Health, Inc., is a large, California based for profit home health agency. Its dividends are expected to grow at a constant rate of 5 percent per year into the foreseeable future. The firm’s last dividend (D(0)) was $1, and its current stock prices is $10. The firm’s beta coefficient is 1.2; the rate of return on 20 year T-bonds currently is 8 percent; and the expected rate of return on the market, as reported by a large financial services firm, is 14 percent. Golden State’s target capital structure class for 60 percent debt financing, the interest rate required on its new debt is 9 percent, and the firm’s tax rate is 30 percent.
a. What is the firm’s cost of equity estimate according to the DCF method?
b. What is the cost of equity estimate according to the CAPM?
c. On the basis of your answers to parts a and b, what would be your final estimate for the firm’s cost of equity?
d. What is your estimate for the firm’s corporate cost of capital?
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