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Assignment # 4 – Medical Associates

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HSA 525-Health Financial Management
Assignment # 4 – Medical Associates
November 27, 2011

Medical Associates: Equity cost of capital, DCF, CAPM, risk, capital budgeting
Medical Associates is a large for-profit group practice. Its dividends are expected to grow at a constant rate of 7% per year into the foreseeable future. The firm's last dividend (D0) was $2, and its current stock price is $23. The firm's beta coefficient is 1.6; the rate of return on 20-year T-bonds currently is 9%; the expected rate of return is 13%. The firm's target capital structure calls for 50% debt financing, the interest rate required on the business's new debt is 10%, and its tax rate is 40%.

1. Calculate Medical Associates' cost of equity estimate using the DCF method.
Using the DCF method
Cost of Equity = D1/P0 + g
D1 = expected dividend= D0 X (1+g) = 2 X 1.07 = 2.14
P0 current price = $23 g = growth rate = 7%
Cost of equity = 2.14/23 + 7% = 16.30%

2. Calculate the cost of equity estimate using CAPM.
Using CAPM
Cost of equity = Rf + (Rm-Rf) beta
Rf = risk free rate = 9%
Rm = return on market = 13% beta = 1.6
Cost of equity = 9% + (13%-9%) 1.6 = 15.4%

3. On the basis of your answers to #1 & #2, what is your final estimate for the firm's cost of equity?
We take the average of the two costs as the final estimate
Final estimate is the average of the two = (16.3%+15.4%)/2 = 15.85%

4. Calculate the firm's estimate for corporate cost of capital.
Cost of Capital = Proportion of debt X after tax cost + Proportion of equity X cost of equity
= 0.5 X 10% X (1-0.4) + 0.5 X 15.85%
= 10.93%

5. Describe the four (4) steps of capital budgeting analysis.
The four steps of Capital Budgeting analysis normally involves the following four steps: • Estimate the projects expected cash flows, which consist of the following: a.The capital

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