Medical Associates

Assignment #5

Teresa Arledge

Dr. Laura Forbes

HAS 525

February 26, 2012

Medical Associate 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 firms last dividend was $2 and its current stock price $ 23. The firm’s beta coefficient is 1.6 the rate of return on 20 – year T bonds currently is 90% 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 40%

1. Calculate Medical Associates cost of equity estimate using the DCF method.

Using the DCF method:

Cost of Equity = D1/ PO + G

D1 = expected dividend = DOX (1 + g)

= 2X 1.07 =2.14

PO current price = $23

G = growth rate = 7%

Cost of Equity = 2 x 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 market = 13%

Beta = 1.6

Cost of Equity = 9% + (13% - 9%) 1.6 = 15.4%

3. On the basis of our answers to #1 & #2 what is your firms cost of equity? I would take the average of two costs as the final estimate. Final Estimate is the average of the two: ( 16.3% + 15.4%)/2 = 15.8%.

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.

0.5X 10% X ( 1- 0.4) + 0.5 X 15.85 = 10.93%

5. Describe the four steps of capital budgeting analysis

The four steps of capital budgeting analysis are:

1. Estimate the project’s expected cash flow, which consist of the following:

a. The capital outlay, or cost

b. The operating cash flows

c. The terminal (ending) cash flow

2. The riskiness of the estimated cash flows must be assessed.

3. Given the riskiness of the project, the project’s cost of capital (opportunity cost or discount rate) is estimated.

4....