HSA 525-Health Financial Management
Assignment # 4 – Medical Associates
November 27, 2011
Medical Associates: Equity cost of capital, DCF, CAPM, risk, capital budgeting
Medical Associates is a large for-profit group practice. Its dividends are expected to grow at a constant rate of 7% per year into the foreseeable future. The firm's last dividend (D0) was $2, and its current stock price is $23. The firm's beta coefficient is 1.6; the rate of return on 20-year T-bonds currently is 9%; the expected rate of return is 13%. The firm's target capital structure calls for 50% debt financing, the interest rate required on the business's new debt is 10%, and its tax rate is 40%.
1. Calculate Medical Associates' cost of equity estimate using the DCF method.
Using the DCF ...view middle of the document...
3%+15.4%)/2 = 15.85%
4. Calculate the firm's estimate for corporate cost of capital.
Cost of Capital = Proportion of debt X after tax cost + Proportion of equity X cost of equity
= 0.5 X 10% X (1-0.4) + 0.5 X 15.85%
5. Describe the four (4) steps of capital budgeting analysis.
The four steps of Capital Budgeting analysis normally involves the following four steps:
• Estimate the projects expected cash flows, which consist of the following:
a.The capital outlay, or cost
b.The operating cash flow
c.The terminal (ending) cash flow
• The riskiness of the estimated cash flows must be assessed.
• Given the riskiness of the project, the project’s cost of capital is estimated.
• The financial impact of the project, including profitability, is assessed.
6. Describe how is project risk is incorporated into a capital budgeting analysis.
The project risk is incorporated by changing the discount rate. A higher risk project than the average risk of the company would have a higher rate and a lower risk project would have a lower rate. The project risk can be found out by using the pure play approach. We look for a business which is in the same line as the project and get the beta of that business which is the proxy for the project risk.
Another rough and ready method is the add 2% to WACC for high risk projects and subtract 2% for low risk projects.
Gapenski, L.C. (2008). Health finance: An introduction to accounting and financial management.
(4th ed). Chicago: AUPHA Press/ Health Administration Press.
Financial Web. (2009). The Basic Steps of Capital Budgeting. Retrieved from http://www.finweb.com/financial-planning/the-basic-steps-of-capital-budgeting.html