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UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT

5/1/10

Chapter 16 -- Business Valuation, Mergers, and Acquisitions


PROBLEM 1
Assume that you have been asked to place a value on the ownership position in Briarwood Hospital. Its
projected profit and loss statements and retention requirements are shown below (in millions):

Net revenues
Cash expenses
Depreciation
Earnings before interest and taxes
Interest
Earnings before taxes
Taxes (40 percent)
Net profit
Estimated retentions

Year 1
Year 2
Year 3
Year 4
Year 5
$225.0
$240.0
$250.0
$260.0
$275.0
$200.0
$205.0
$210.0
$215.0
$225.0
$11.0
$12.0
$13.0
$14.0
$15.0
$14.0
$23.0
$27.0
$31.0
$35.0
$8.0
$9.0
$9.0
$10.0
$10.0
$6.0
$14.0
$18.0
$21.0
$25.0
$2.4
$5.6
$7.2
$8.4
$10.0
$3.6
$10.0

$8.4
$10.0

$10.8
$10.0

$12.6
$10.0

$15.0
$10.0

Briarwood's cost of equity is 16 percent, its cost of debt is 10 percent, and its optimal capital structure is
40 percent debt and 60 percent equity. The best estimate for Briarwood's long-term growth rate is 4
percent. Furthermore, the hospital currently has $80 million in debt outstanding.
a. What is the equity value of the hospital using the Free Operating Cash Flow (FOCF) method?
b. Suppose that the expected long-term growth rate was 6 percent. What impact would this change have
on the equity value of the business according to the FOCF method? What if the growth rate were
only 2 percent?
c. What is the equity value of the hospital using the Free Cash Flow to Equityhloders (FCFE) method?
d. Suppose that the expected long-term growth rate was 6 percent. What impact would this change have
on the equity value of the business according to the FCFE method? What if the growth rate were
only 2 percent?
ANSWER

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT


Chapter 16 -- Business Valuation, Mergers, and Acquisitions
PROBLEM 2
Assume that you have been asked to place a value on the fund capital (equity) of BestHealth, a
not-for-profit HMO. Its projected profit and loss statements and retention requirements are
shown below (in millions):

Net revenues
Cash expenses
Depreciation
Interest
Net profit
Estimated retentions

Year 1
Year 2
Year 3
Year 4
Year 5
$50.0
$52.0
$54.0
$57.0
$60.0
$45.0
$46.0
$47.0
$48.0
$49.0
$3.0
$3.0
$4.0
$4.0
$4.0
$1.5
$1.5
$2.0
$2.0
$2.5
$0.5
$1.5
$1.0
$3.0
$4.5
$1.0
$1.0
$1.0
$1.0
$1.0

The cost of equity of similar for-profit HMO's is 14 percent, while BestHealth's cost of debt is 5
percent. Its current capital structure is 60 percent debt and 40 percent equity. The best estimate
for BestHealth's long-term growth rate is 5 percent. Furthermore, the HMO currently has
$30 million in debt outstanding.
a. What is the equity value of the HMO using the Free Operating Cash Flow (FOCF) method?
b. Suppose that it was not necessary to retain any of the operating income in the business. What
impact would this change have on the equity value according to the FOCF method?

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT


Chapter 16 -- Business Valuation, Mergers, and Acquisitions
PROBLEM 3
Columbia Home Care Inc. is considering a merger with HCA Home Care Inc. HCA is a publicly
traded company, and its current beta is 1.30. HCA has been barely profitable and had paid an average
of only 20 percent in taxes during the last several years. In addition, it uses little debt, having a debt
ratio of just 25 percent. If the acquisition were made, Columbia would operate HCA as a separate,
wholly owned subsidiary. Columbia would pay taxes on a consolidated basis, and the tax rate would
therefore increase to 35 percent. Columbia also would increase the debt capitalization in the HCA
subsidiary to 40 percent of assets, which would increase its beta to 1.50. Columbia estimates that
HCA, if acquired, would produce the following net cash flows to Columbia's shareholders (in millions
of dollars):
Year
1
2
3
4
5 and beyond

Free Cash Flows to Equityholders


$1.30
$1.50
$1.75
$2.00
Constant growth at 6%

These cash flows include all acquisition effects. Columbia's cost of equity is 14 percent, its beta is 1.0,
and its cost of debt is 10 percent. The risk-free rate is 8 percent.
a. What discount rate should be used to discount the estimated cash flow? (Hint: Use Columbia's cost of
equity to determine the market risk premium.)
b. What is the dollar value of HCA to Columbia's shareholders?
ANSWER

UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT


Chapter 16 -- Business Valuation, Mergers, and Acquisitions
PROBLEM 4
Hastings HMO is interested in acquiring Vandell, a smaller HMO in its service area. Vandell has
1 million shares outstanding and a target capital structure consisting of 30 percent debt. Vandell's
debt interest rate is 8 percent. Assume that the risk-free rate of interest is 5 percent and the market
risk premium is 6 percent. Both Vandell and Hastings face a 40 percent tax rate.
Vandell's Free Operating Cash Flow is $2 million per year and is expected to grow at a constant
rate of 5 percent a year; its beta is 1.4. If Vandell has $10.82 million in debt, what is the current
value of Vandell's stock? What price per share should Hastings bid for each share of Vandell
common stock?
ANSWER