Cost of Capital

1. What corporate cost of capital (CCC)

do you estimate for Southeastern Homecare?

2. The companyA????1s financial plan calls for the iss

ue of 30-year bonds to meet

long-term debt needs. How

valid is an estimate of the cost of debt based on 15-ye

ar bonds? If the estimate is

not valid, how might it

be adjusted to remove any bias?

3. The Board Chair is concerned about factors that affe

ct the corporate cost of capital for any business:

the level of interest rates, tax rates, capital struct

ure policy, and capital invest

ment policy. Does the tax

rate, cost of debt, or cost of equity have the

most influence on the CCC of Southeastern Homecare?

Why? (Hint: In one graph, show the CCC at +/- 25%

and 50% values of the tax rate, cost of debt, and

cost of equity.)

4. Southeastern Homecare has two

operating divisions: the Health

care Services Division and the

Information Systems Division.

a. Estimate the divisional cost of capital for

each of SoutheasternA????1s divi

sions assuming that both

divisions have the same optimal (target) capital st

ructure. (Hint: Use the CAPM to produce a cost

of equity for each division and assume the same

corporate tax rate and debt cost for each

division.)

b. SoutheasternA????1s divisions are each considering two

investment opportunities for next year. In which

of the projects should Southeastern invest?

c. The divisional presidents have expressed concern

that a single cost of capital will be applied across

the company, regardless of any divisional risk diffe

rences. What would be the short-term and long-

term consequences of Southeastern using a si

ngle cost of capital for both divisions?

d. Is the divisional cost of

capital applicable for all projects

within that division? Explain.

e. Suppose that one division has a greater capacit

y for debt financing than the other (perhaps due to

higher asset value and profitability.) How could di

fferent target capital structures be incorporated

into the divisional costs of capital?

5. The founders of Southeastern are concerned about the threat posed by home health care businesses

started by not-for-profit hospitals. Using your ans

wer to Question 4a and the data in Table 18.3,

estimate the cost of capital for the homecare divisi

on of an average not-for-profit hospital. How much

confidence do you have in the cost of capital estimate? Why?

6. One of SoutheasternA????1s directors has express

ed concern over the difference between the companyA????1s

target capital structure and the current st

ructure as reported on the balance sheet.

a. What are the book values of SoutheasternA????1s

long-term debt and equity? What are the current

market values of SoutheasternA????1s long-term debt and equity?

b. What are SoutheasternA????1s target

weights, book value weights, and current market value weights of

long-term debt and equity (that is, long-term debt /

total capital and common stock / total capital)?

c. Which set of weights should be used in t

he corporate cost of capital estimate? Why?

7. In your opinion, what are thr

ee key learning points from this case?

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