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# Equity and Rate of Return

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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 = ...

#### Solution Summary

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## Stocks, Equity and Rate of Return

1.) Twister Corporation is expected to pay a dividend of \$7 per share one year from now on its common stock, which has a current market price of \$143. Twister's dividends are expected to grow at 13%.
a) Calculate the cost of the company's retained earnings.
b) If the flotation cost per share of new common stock is \$4.00, calculate the cost of issuing new common stock.

2.) Free Willy, Inc. (Nasdaq: FWIC) has a beta of 1.4. If the rate on U.S. Treasury bills is 4.5% and the expected rate of return on the stock market is 12%, what is Free Willy's cost of common equity financing?

3.) Alvin C. York, the founder of York Corporation, thinks that the original capital structure of his company is 30% debt,
15% preferred stock, and thje rest common equity. If the company is in the 40% tax bracket, compute its weighted
average cost of capital given that:
* YTM of its debt is 10%.
* New preferred stock will have a market value of \$31, a a dividend of \$2 per share, and flotation costs of \$1pershare.
* Price of common stock is currently \$100 per share, and new common stock can be issued at the same price with flotation costs of \$4 per share. The expected dividend in one year is \$4 per share, and the growth rate is 6%.

4.) Three separate projects each have an initial cash outlay of \$10,000. The cash flow for Peter's Project is \$4,000 per year for 3 years. The cash flow for Paul's project is \$2,000 in years 1 and 3, and \$8,000 in year 2. Mary's Project has a cash flow of \$10,000 in year 1, followed by \$1,000 each year for years 2 and 3.
a) Use the payback method to calculate how many years it will take for each project to recoup the initial investment.

b.) Which project would you consider most liquid?

5.) You have just paid \$20 million in the secondary market for the winning Powerball lottery ticket, The prize is \$2 million at the end of each year for the next 25 years. If your required rate of return is 8%, what is the net present value (NPV)of the deal?

6.) What is the internal rate of return (IRR) of the Powerball deal in question 5?

7.) What is the modified internal rate of return (MIRR) of the Powerball deal in question 5?

8.) Assume that Intel Corporation's \$1,000 face value 9% coupon rate bond matures in 10 years and sells for \$1,100. If you purchase the bond for \$1,100 and hold it to maturity, what will be your average annual rate of
return on the investment?

9.) China S. Construction, \$4 per share dividend, growth rate is 1%, required rate of retrn is 16%.
a) What is the present value of the expected dividends from one share of stock?
b.) What is the stock's dividend yield (D1/P0)?

10.)The current price per share of common stock is \$15. The expected cash dividend in one year is \$2 per share. The constant growth rate is 4%. What is the rate of return on this stock at the current price?

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