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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E (D1) D0 [1 + E (g)] = 13.6%. (Assuming that the growth rate is constant)

(Assuming that Southeastern Homecare has a constant growth rate of 10%)

If Southeastern Home care’s historical 50 percent dividend payout is expected to continue into the future, then the Retention rate = 1 Payout rate = 1 − 0.50 = 0.50, and hence E (g) = 0.50(20%) = 10.0%. The return on equity on new investment will equal the firm's current ROE, which implies that the return on equity will remain constant.

The Southeastern’s cost of equity is 13.4% (CAPM approach)

Southeastern’s corporate cost of capital (CCC) is about 10.1 percent:

CCC = wdR (Rd) (1 – T) + weR (Re).

= 0.35(8.0%) (0.6) + 0.65(13.0%) = 1.68% + 8.45% = 10.13%, or about 10.1%.

Southeastern’s overall corporate cost of capital, 10.1 percent, reflects the overall riskiness of the firm as seen by its investors. The Healthcare Services Division, which represents 60 percent of the firm's assets, has an estimated beta of 1.0, Therefore, the Information Systems Division must have a beta of 2.0

(0.60(1.0) + 0.40x = 1.4

0.40x = 0.8 x = 2.0

Assuming the same corporate tax rate and debt cost for each division

Healthcare Services Division

R (Re) = RF + [R (RM) – RF)] b

= 5.0% + (11.0% – 5.0%) 1.0

= 5.0% + 6.0% = 11.0%.

CCC = wdR (Rd) (1 – T) + weR (Re)

= 0.35(8.0%) (0.6) + 0.65(11.0%) = 1.68% + 7.15% = 8.83,