Essay on Southern Homecare Cost Of Capital Case

1080 Words Jan 28th, 2015 5 Pages
SOUTHEASTERN HOMECARE
Cost of Capital
Background
Southeastern Homecare was initially a taxable partnership owned organization run by three partners, but later due to lack of capital and the rapid growth of the organization, the company was incorporated and the stocks were sold to the public. The company has two operating divisions: the Healthcare Services Division and the Information Systems Division. Both these divisions provide different services and operate individually. The Information Systems Division operates on a larger scale and competes with the market; it owns more business risk as compared to the other division. However, due to recent changes in the market and rising competition from the other home healthcare facilities and
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The company will incur floatation since before tax cost of the new debt will be higher than 8%. It can be included in calculating the cost of debt but these costs are reduced for taxable issuers and therefore can be expensed over the life of the issue.

The 8 percent pre-tax estimate is the nominal cost of debt. Because the firm's debt has semiannual coupons, its effective annual cost rate is 8.16 percent
EAR = (1.04)2 – 1.0 = 1.0816 – 1.0 = 0.0816 = 8.16%.
Because the difference between nominal and effective costs usually is small, it is generally ignored.
The yield to maturity on a 15-year bond is a true estimate of the cost of 30-year bond
If the debt had not been recently traded, then other methods of estimating the cost of debt are by estimating the cost of new BBB rated issues of other firms.
Retained earnings will deprive the shareholder’s opportunity to reinvest the dividends in stock or bonds. So the shareholders are given the same amount as they would have received as retained earnings through dividends and so in such case the company incurs a cost for retaining the earnings.
The cost of equity (using the CAPM) approach:
R (Re) = RF + [R (RM) ─ RF)] b
= 5.0% + (11.0% ─ 5.0%) 1.4
= 5.0% + 8.4% = 13.4%. DCF (Direct Cash Flow) = 13.6 DC+ RP = 12.3
The T- bills are less risky as compared to the T-bonds. T-bonds have a price risk premium…