a. Why is there a cost to retained earnings in investor-owned businesses?
b. What are the three methods commonly used to estimate the cost of equity?
c. Is the risk premium in the CAPM the same as the risk premium in the debt-cost-plus-risk-premium model?
d. How would you estimate the cost of equity (fund capital) for a not-for-profit business?
e. How would you estimate the cost of equity for a small investor- owned business?
13.10 For any given firm, can the corporate cost of capital be used as the hurdle rate for all projects under consideration? Explain your answer.
Problems
13.1 Seattle Health Plans currently uses zero-debt financing. Its operating income (EBIT) is $1 million, and it pays taxes at a 40 percent rate. It has $5 million in assets and, because it is all-equity financed, $5 million in equity. Suppose the firm is considering replacing half of its equity financing with debt financing bearing an interest rate of 8 percent.
a. What impact would the new capital structure have on the firm's net income, total dollar return to investors, and ROE?
b. Redo the analysis, but now assume that the debt financing would cost 15 percent.
c. Return to the initial 8 percent interest rate. Now, assume that EBIT could be as low as $500,000 (with a probability of 20 percent) or as high as $1.5 million (with a probability of 20 percent). There remains a 60 percent chance that EBIT would be $1 million. Redo the analysis for each level of EBIT, and find the expected values for the firm's net income, total dollar return to investors, and ROE. What lesson about capital structure and risk does this illustration provide?
d. Repeat the analysis required for Part a, but now assume that Seattle Health Plans is a not-for-profit corporation and pays no taxes. Compare the results with those obtained in Part a.
13.3 St. Vincent's Hospital has a target capital structure of 35 percent debt and 65 percent equity. Its cost of equity (fund capital) estimate is 13.5 percent and its cost of tax-exempt debt estimate is 7 percent. What is the hospital's corporate cost of capital?