Cost of Capital
1. What corporate cost of capital (CCC)
do you estimate for Southeastern Homecare?
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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
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?