Essay on Southern Homecare Cost Of Capital Case

Because the case is nondirected, there is ample opportunity for students to be creative in their solution approaches. Thus, it is impossible to provide a single solution here that is applicable to every student's work. As a starting point in evaluating students' solutions, we provide a solution that is based on the questions contained in online Case Questions section. It is important, however, to recognize that this solution is merely a starting point, and student work should be graded at least as much on the

1. If a company reports retained earnings of $175.3 million on its balance sheet, it must also report $175.3 million in cash.

There are two considerations when determining whether or not to invest in a debt product. These are the rate of return and the credit quality of the issuer. The credit quality of the US Treasury is very high, because the Treasury prints money. Thus, the holder of a T-bill knows for certain that the face value will be paid. The only question for the holder, then, is with respect to the real value of that payment. T-bills are a safe way to earn a small interest rate, and in that respect are often better than holding cash. Unless the financial institution is paying a higher rate on its accounts than the T-bill rate, cash will have a lower real return than a T-bill. However, this is possible, if the bank intends to reinvest that money at a higher rate, say in loans to consumers or small businesses. The bank might in that case offer a higher real rate of return than T-bills in order to entice customers to make deposits.

(1- Tax Rate) * E / (E + D) * Cost of Equity + D / (E + D) * Cost of Debt

The lower of the two calculation, YTM and YTC, for each bond are chosen and averaged. By averaging bond A’s YTM and bond B’s YTC, the before-tax cost of debt is 7.52% (Table 1). Therefore, a reasonable estimate of the company’s cost of debt for use in the WACC calculation is 4.51%, the after-tax cost of debt (Table 1). Additionally, the estimate of the company’s cost of debt implies that the slope of PNC’s yield curve is flat; little difference exists between the determined rates.

When a firm uses debt, the interest tax shield provides a corporate tax benefit each year. In order to determine the benefit of leverage for the value of the firm, we must compute the present value of the stream of future interest tax shields the firm will receive.

The rate applied to determine the cost of debt should be the current market rate the company is paying on its debt. The forecasted cost of debt after tax is defined as 5%. Based on the Capital Asset Pricing Model (CAPM), where: Cost of Equity (Re) = Rf + Beta (Rm-Rf), DJS has an estimated cost of equity of approximately 13% (4.5% + 1.38 * 6%), representing a risk free rate of 4.5%, the beta of 1.38 sourced from Aspect Fin Analysis, and the market premium of 6%. (Table 2)

* We assumed that the cost of debt and ITS for each contract, is equal to the interest rate (e.g. cost of debt and ITS for senior notes is 11.25%)

As we see in Exhibit B in the appendix, with an increase of 10, 20, and 30 debt to total capital, we see our ROE increase to 9.52, 10.19, and 11.05 respectively. However this increase in ROE comes at a price, as the overall risk of the company is increased with the addition of the debt obligations. In Exhibit B, we see that the beta of equity increase as we increase our debt in the capital structure, and increasing beta indicates increased systematic risk for the firm. This increase in beta is also a factor that contributes to the increased cost of equity. As shown in Exhibit B, the cost of equity increases 21 bps with the addition of 10 debt, 43 bps with the addition of 20 debt, and 67 bps with the addition of 30 debt into the capital structure. The increased basis points come as investors will begin to demand a higher rate of return on their investment as more debt is added to the structure because, as residual claimants, their claim to assets are reduced in favor of the bond holders. This increased rate will make it more difficult to raise future capital in the equity market if needed. However, by issuing debt which has a lower cost of capital at 6.16 and repurchasing equity that has a cost of capital of 13.37 (unlevered), the company can reduce its overall cost of capital, or the weighted average cost of capital (WACC). The WACC is measured by taking the weight of debt

BECAUSE OF THE DIFFERENCE IN TAX RATES FOR INTEREST PAYMENTS (ORDINARY INCOME) AND DIVIDENDS (15% - 25%) AS DEBT IS ADDED TO THE STRUCTURE THE PAYMENTS ARE MADE TO INVESTORS IN THE FORM OF INTEREST PAYMENTS. INTEREST PAYMENTS ARE TAXED AT ORDINARY INCOME WHICH SHOULD BE HIGHER THAN 25%. THE VALUE OF THE FIRM WILL DECREASE UNDER THIS SCENARIO.

d. Earnings per share (EPS) = Earnings After Taxes(EAT)/Outstanding Shares. If the number of outstanding shares is reduced by a buyback of shares then the EPS will increase if the EAT remains unchanged. However the EAT is reduced since there is interest expense. If the dividend

Moreover, it is clear status that the longer the maturities of a bond, the more its prices diversify that induces to changing in interest rate if other elements are constant. As stated case, Bond B has a longer period of time to maturity and lower coupon rate than Bond A. The Bond B's interest rate is more sensitive than Bond A since its returns come from the principal repayment and interest rate risk will exposure at that time.

The annual interest expenses should be ignored. This is done to avoid double counting the interest expense. The after-tax cost of borrowing is included in the weighted average cost of capital or discount rate. By discounting the cash flows to calculate the Net Present Value, interest costs are factored in.

Since we are initially ignoring the effects of taxes and do not know the required return, (we initially know only that debt costs 8% but are not provided any information regarding equity costs) the only available option is to use either a non-time value based evaluation or the internal rate of return:

Weighted Average Cost of Capital D E WACC = rd(1 – t) –– + re –– C C Cost of Internal Capital re (CAPM2 model) 18.,42% = 10.5 + (1.1 x