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Equity and Rate of Return

Southern Healthcare and BestWell are for-profit HMOs that operate in Florida and Georgia. Currently, both are identical in every respect except that Southern is unleveraged while BestWell has $10 million of 5 percent bonds. Both HMOs report an EBIT of $2 million and pay corporate tax at a rate of 40 percent. The cost of equity to Southern is 10 percent. Assume that all of the MM assumptions hold.

a. What total value would MM estimate for each HMO?
b. What is the value of the equity of each HMO?
c. What is the required rate of return on equity for each HMO?
d. What is the corporate cost of capital for each HMO?

Solution Preview

a) Computing the total value of Southern Healthcare:
Vu = [EBIT(1- Tc)] /Ru
where Tc is the tax rate
Ru is the cost of capital.
Vu is the unlevered
Vu = [$2,000,000 (1-0.40)] / 0.10
= $1,200,000 / 0.10
= $12,000,000
Therefore, the total value of Southern Healthcare firm is $12,000,000

Computing the total value of Best Well :
Vl = ...

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