CASE17CASE 19 Instructor VersionCopyright 2014 Health .docx

CASE17CASE 19 Instructor VersionCopyright 2014
Health Administration Press11/26/14 RN
TEMPS, INC. Capital Structure AnalysisThis
case illustrates the capital structure decision for a firm that
begins with zero debtfinancing.The spreadsheet consists of two
separate models: 1) Debt amount and ROE (Rows 35-43) uses
income statements to examine the effects of financial leverage
on ROE. This model uses a single (constant) interest rate
input for all capital structure scenarios.2) Debt amount and
Stock Price / CCC (Rows 45-56) examines the effects of debt
financing on firm value, cost of capital, and stock price,
assuming zero growth (perpetual cash flows.)The model consists
of a complete base case analysis--no changes need to be madeto
the existing MODEL-GENERATED DATA section. However,
all values in the INPUT DATAsection of the student version
have been replaced with zeros. Thus, students must
determinethe appropriate input values and enter them into the
model. These cells are colored red.When this is done, any error
cells will be corrected and the base case solution will
appear.Note that the model does not contain any risk analyses,
so students will have to createtheir own if required by the case.
Furthermore, students must create their own graphics(charts) as
needed to present their results.The instructor version of the
model contains a sheet (Figure 1) that plots both stock priceand
cost of capital versus the dollar amount of debt financing. It
also contains sheets thatcontain the inputs and outputs for the
increased and decreased business risk scenarios.INPUT DATA:
KEY OUTPUT:Tax rate40.0% Debt Amount and ROE
Input:Debt Amount and ROE Analysis:Market
value$12,000,000ExpectedCost of debt10.0%ROESD of ROEAll
Equity15.0%1.8%ProbabilityEBIT25%
Debt18.0%2.4%0.25$2,500,00050%
Debt24.0%3.5%0.5$3,000,00075%
Debt42.0%7.1%0.25$3,500,000 Debt Amount and Stock Price /

CCC Input:Debt Amount and Stock Price / CCC
Analysis:EBIT$3,000,000No. of shares 10,000,000Debt
AmountCost of DebtCost of EquityDebt AmountStock PriceCCC
$00.0%15.0%$0$1.20015.0%2,500,00010.0%15.5%2,500,000$1.
31513.7%5,000,00011.0%16.5%5,000,000$1.39112.9%7,500,00
013.0%18.0%7,500,000$1.42512.6%10,000,00016.0%20.0%10,0
00,000$1.42012.7%12,500,00020.0%25.0%12,500,000$1.37013.
1%MODEL-GENERATED DATA: Debt and ROE Analysis:
All Equity 25%
DebtProbability0.250.500.250.250.500.25EBIT$2,500,000$3,00
0,000$3,500,000$2,500,000$3,000,000$3,500,000Interest00030
0,000300,000300,000
EBT$2,500,000$3,000,000$3,500,000$2,200,000$2,700,000$3,2
00,000Taxes1,000,0001,200,0001,400,000880,0001,080,0001,28
0,000Net
Income$1,500,000$1,800,000$2,100,000$1,320,000$1,620,000$
1,920,000ROE12.5%15.0%17.5%14.7%18.0%21.3%TIE
Ration.a.n.a.n.a.8.3310.0011.67E(ROE)15.0%18.0%Std dev of
ROE1.8%2.4%Coefficient of variation0.120.13 50% Debt
75%
DebtProbability0.250.500.250.250.500.25EBIT$2,500,000$3,00
0,000$3,500,000$2,500,000$3,000,000$3,500,000Interest600,00
0600,000600,000900,000900,000900,000
EBT$1,900,000$2,400,000$2,900,000$1,600,000$2,100,000$2,6
00,000Taxes760,000960,0001,160,000640,000840,0001,040,000
Net
Income$1,140,000$1,440,000$1,740,000$960,000$1,260,000$1,
560,000ROE19.0%24.0%29.0%32.0%42.0%52.0%TIE
Ratio4.175.005.832.783.333.89E(ROE)24.0%42.0%Std dev of
ROE3.5%7.1%Coefficient of variation0.150.17 Debt Amount
and Stock Price / CCC Analysis:Market ValueMarket
ValueTotalStockNumber ofEarnings perof Debtof
EquityValueDebt RatioPriceCCCSharesShare
(EPS)$0$12,000,000$12,000,0000.0%$1.20015.0%10,000,000$0
.182,500,00010,645,16113,145,16119.0%1.31513.7%8,098,160$
0.205,000,0008,909,09113,909,09135.9%1.39112.9%6,405,229$

0.237,500,0006,750,00014,250,00052.6%1.42512.6%4,736,842$
0.2610,000,0004,200,00014,200,00070.4%1.42012.7%2,957,746
$0.2812,500,0001,200,00013,700,00091.2%1.37013.1%875,912
$0.34 Optimal Debt Level =$7,500,000END
Figure1
STOCK PRICE AND COST OF CAPITAL
1.2 1.3145161290322582 1.3909090909090909 1.425
1.42 1.37 0.15 0.13693251533742332
0.12941176470588234 0.12631578947368421
0.12676056338028169 0.13138686131386862
Amount of Debt ($)
Increased Business RiskCASE 17 Instructor Version
(Increased Business Risk)Copyright 2014 By FACHE
RN TEMP SERVICES, INC. Capital Structure
DecisionsThis sheet contains the increased business risk
scenario valuation.INPUT DATA: KEY OUTPUT: Debt
Amount and ROE Input:Debt Amount and ROE Analysis:Total
value$12,000,000Debt AmountStock PriceCCC Cost of
debt12.0%$0$1.1316.0%EBIT$3,000,0002,500,0001.2114.9%Ta
x rate40.0%5,000,0001.2414.5%No. of shares
10,000,0007,500,0001.2414.5%10,000,0001.2314.6%12,500,000
1.2314.7% Debt Amount and Stock Price / CCC Input:Debt
AmountCost of
Debt$00.0%2,500,00011.0%5,000,00013.0%7,500,00016.0%10,
000,00020.0%12,500,00025.0%Debt AmountCost of
Equity$016.0%2,500,00017.0%5,000,00019.0%7,500,00022.0%
10,000,00026.0%12,500,00031.0%MODEL-GENERATED
DATA: Debt Amount and Stock Price / CCC Analysis:Market
ValueMarket ValueTotalStockNumber ofEarnings perof Debtof
(EPS)$0$11,250,000$11,250,0000.0%$1.12516.0%10,000,000$0
.182,500,0009,617,64712,117,64720.6%1.21214.9%7,936,8930.

215,000,0007,421,05312,421,05340.3%1.24214.5%5,974,5760.2
47,500,0004,909,09112,409,09160.4%1.24114.5%3,956,0440.27
10,000,0002,307,69212,307,69281.3%1.23114.6%1,875,0000.32
12,500,000(241,935)12,258,065102.0%1.22614.7%(197,368)0.3
8Optimal Debt Level:$5,000,000END
Decreased Business RiskCASE 17 Instructor Version
(Decreased Business Risk)Copyright 2014 By FACHE
RN TEMPS SERVICES, INC. Capital
Structure DecisionsThis sheet contains the decreased business
risk scenario valuation.INPUT DATA: KEY OUTPUT: Debt
Amount and ROE Input:Debt Amount and ROE Analysis:Total
value$12,000,000Debt AmountStock PriceCCC Cost of
debt12.0%$0$1.2914.0%EBIT$3,000,0002,500,0001.4112.7%Ta
x rate40.0%5,000,0001.5111.9%No. of shares
10,000,0007,500,0001.5811.4%10,000,0001.6011.3%12,500,000
1.5711.5% Debt Amount and Stock Price / CCC Analysis:Debt
AmountCost of
Debt$00.0%2,500,0009.0%5,000,0009.5%7,500,00010.5%10,00
0,00012.5%12,500,00015.5%Debt AmountCost of
Equity$014.0%2,500,00014.3%5,000,00015.0%7,500,00016.0%
10,000,00017.5%12,500,00020.0%MODEL-GENERATED
DATA: Debt Amount and Stock Price / CCC Analysis:Market
ValueMarket ValueTotalStockNumber ofEarnings perof Debtof
(EPS)$0$12,857,143$12,857,1430.0%$1.28614.0%10,000,000$0
.182,500,00011,643,35714,143,35717.7%1.41412.7%8,232,3860
.205,000,00010,100,00015,100,00033.1%1.51011.9%6,688,7420
.237,500,0008,296,87515,796,87547.5%1.58011.4%5,252,2260.
2510,000,0006,000,00016,000,00062.5%1.60011.3%3,750,0000.
2812,500,0003,187,50015,687,50079.7%1.56911.5%2,031,8730.
31Optimal Debt Level:$10,000,000END
CASE16CASE 18 Instructor VersionCopyright 2014
Health Administration Press11/26/14 SOUTHEASTERN
HOMECARE Cost of CapitalThis case illustrates the
cost of capital estimation for a business with two divisions

thatoperate in diverse business lines.The spreadsheet calculates
the cost of debt based on the yield to maturity and the yieldto
call of debt issues that are currently outstanding. It also
calculates the cost of equity onthe basis of three models:
CAPM, DCF, and Debt Cost + Risk Premium.Students must use
judgment when making the final estimates for the costs of debt
and equity.These estimates must be entered into the lower part
of the INPUT DATA section to calculatethe corporate cost of
capital. Divisional costs of capital can be estimated using the
samepart of this spreadsheet, but with the appropriate divisional
input data.The model consists of a complete base case analysis--
however, all values in the INPUT DATAsection of the student
version have been replaced with zeros. Thus, students must
determinethe appropriate input values and enter them into the
model. These cells are colored red.When this is done, any error
cells will be corrected and the base case solution will
appear.Note that the model does not contain any risk analyses,
so students will have to createtheir own if required by the case.
Furthermore, students must create their own graphics(charts) as
needed to present their results.INPUT DATA: KEY OUTPUT:
Cost of Debt Input: Cost of Debt:Years to maturity15
YTM8.0%Annual coupon payment$75.00 YTC9.8%Current
price$956.31Par value$1,000.00Years to call5Call
price$1,075.00 Cost of Equity Input: Cost of Equity: CAPM
Approach:Beta coefficient1.4 CAPM13.4%Risk-free
rate5.0%Required market return11.0% DCF Approach:Stock
price$5.25 DCF13.6%Last dividend paid$0.17Constant
growth rate10.0% Debt Cost Plus RP Approach:Risk
premium4.0% DC+RP12.0% Corporate Cost of Capital Input:
Corporate Cost of Capital:Tax rate40.0% CCC10.1%Weight of
debt35.0%Weight of equity65.0%Final cost of debt
estimate8.0%Final cost of equity estimate13.0% Effect of
factors on Corporate Cost of Capital:FinalFinalTaxcost ofcost
ofChangeratedebtequity-50%20%4%6.5%-
25%30%6%9.7%0%40%8%13.0%25%50%10%16.2%50%60%12
%19.5% CCC sensitivity analysisFinalFinalTaxcost ofcost

ofChangeratedebtequity-50%10.7%9.3%5.9%-
25%10.4%9.7%8.0%0%10.1%10.1%10.1%25%9.9%10.6%12.2%
50%9.6%11.0%14.4% Book and Market Values:Book value of
long-term debt (millions)$20.0Book value of common stock
(millions)$20.3Total book value$40.3Current bond
price$956.3Bond par value$1,000.0Market value of long-term
debt (millions)$19.1Common shares outstanding
(millions)$10.0Current common share price$5.3Market value of
common stock (millions)$52.5Market value of long-term debt
(millions)$19.1Market value of common stock
(millions)$52.5Total market value$71.6 Target, Book, and
Market Value
Weights:TargetBookMarketValueValueValueWeightsWeightsW
eightsLong-term debt35.0%49.6%26.7%Common
stock65.0%50.4%73.3%Total capital100.0%100.0%100.0%
The component cost inputs below (not the output above) are
used to estimate the CCC.
Corporate Cost of Capital
Tax rate -0.5 -0.25 0 0.25 0.5 0.10690000000000001
0.1041 0.1013 9.8500000000000004E-2
9.57000000000 00007E-2 Cost of debt -0.5 -0.25 0
0.25 0.5 9.2905762158321234E-2
9.7108643237481848E-2 0.10131152431664245
0.10551440539580306 0.10971728647496368 Cost of
equity -0.5 -0.25 0 0.25 0.5
5.9050000000000005E-2 8.0174999999999996E-2 0.1013
0.12242500000000001 0.14355000000000001
Percent change from base case
CASE 19

RN TEMPS, INC.
(Capital Structure Analysis)
Introduction
3 Key Learning Points (KLPs)
This case illustrates capital structure analysis for a very low-
growth business starting with zero debt.The primary goal of this
case is to give you the opportunity to:
Understand the value relationships between different theoretical
models
Understand the importance of qualitative factors when
estimating a business’s optimal capital structure
Introduction
Copyright 2014 Health Administration Press
The case has a spreadsheet model. It consists of two separate
analyses:
The top part examines the impact of financial leverage on return
(as measured by ROE) and risk (as measured by standard
deviation of ROE).
The bottom part examines the relationship between financial
leverage and firm (equity) value using component costs as
inputs and assuming that all cash flows are perpetuities and the
firm starts with zero debt.
Spreadsheet Model
KLP 1: The use of financial leverage has

both benefits and costsWhen debt financing is used, expected
ROE increases, first to 18.0 percent, then to 24.0 percent, and
finally to 42.0 percent.However, this leveraging up of expected
return is not without costs—the standard deviation also
increases, first to 2.4 percent, then to 3.5 percent, and finally to
7.1 percent.
KLP 2: The stock price is maximized at the
debt level that minimizes CCCA capital structure with $7.5
million (52.6%) of debt maximizes the firm’s stock price at
$1.425 and hence is the best structure of those considered.This
should be intuitive because the value of any business is the
present value of its future operating cash flows (which are
unaffected by the financing mix), so the lower the discount rate,
the higher the present value.
KLP 3: The capital structure decision is
influenced by qualitative factors$7.5 million of debt results in
(1) times interest earned and (2) cash and marketable
securities/annual interest expense, which is lower than industry
averages.A debt level of $5 million gives a debt ratio of 35.9%
and affects the stock price by less than four cents. For this
“cost,” RN Temps would obtain a stronger debt rating (A) and a
reserve borrowing capacity.

CASE 18
SOUTHEASTERN HOMECARE
(Cost of Capital)
Introduction
3 Key Learning Points (KLPs)
This case illustrates the cost of capital estimation process for a
home health care business.The primary goal of this case is to
give you the opportunity to:
Estimate a business’s corporate cost of capital.
Estimate divisional costs of capital.
Understand how ownership status (for-profit versus not-for-
profit) affects capital costs.
Introduction
The case has a simple spreadsheet model. It calculates the costs
of debt and equity using several different methodologies.It also
calculates the corporate cost of capital based on your final
estimates for component costs.
Spreadsheet Model

The bonds are selling at a discount, which indicates that interest
rates have risen since the bond was issuedA call is unlikely, so
the 8.0 percent estimate of YTM is the appropriate estimate of
the cost of debt
KLP 1: The YTC would only be used to estimate the cost of
debt if a call is likely
Different costs of capital—Avoids accepting too many high-risk
projects and rejecting too many low-risk projects.Different debt
capacities—The weights of debt and equity may be adjusted for
each division.
KLP 2: It can be important to adjust for divisional differences
Target weights are the percentages of different types of capital
the firm plans to use when it raises capital in the future.
If the target weights are unknown, use market values.
KLP 3: Use target capital structure weights to calculate the
CCC
Cases in Healthcare Finance, 5th Edition Copyright
2014 Health Administration Press
12/6/2013

CASE 19 QUESTIONS
RN TEMPS, INC.
Capital Structure Analysis
1. What is the potential impact of increasing amounts of debt
financing on the ROE and risk of RN Temps
(Tiffany’s first concern)?
2. What is the potential impact of increasing amounts of debt
financing on the firm’s stock price and CCC?
Graph the stock price and CCC at different levels of debt and
interpret the relationships among them
(Tiffany’s second concern).
3. Tiffany’s third concern:
a. What are some potential changes that might affect the
business risk of RN Temps?
b. Use the information in Exhibit 19.3 to analyze the financial
effects of potential changes in business
risk of RN Temps.
4. Calculate the Times Interest Earned and the Cash and
Marketable Securities to Annual Interest

Expense for RN Temps (Tiffany’s fourth concern). Please show
your calculations.
5. Tiffany also wants to know the value of the firm at
$7,500,000 of debt according to the Modigliani-Miller
with corporate taxes model and the Miller model.
6. Considering all the information available in this case, what is
your best estimate for the optimal (target)
capital structure of RN Temps?
7. In your opinion, what are three key learning points from this
case?
Cases in Healthcare Finance, 5th Edition Copyright 2014
Health Administration Press
12/6/2013
CASE 18 QUESTIONS
SOUTHEASTERN HOMECARE
Cost of Capital

1. What corporate cost of capital (CCC) do you estimate for
Southeastern Homecare?
2. The company’s financial plan calls for the issue of 30-year
bonds to meet long-term debt needs. How
valid is an estimate of the cost of debt based on 15-year 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 affect the
corporate cost of capital for any business:
the level of interest rates, tax rates, capital structure policy, and
capital investment 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
Healthcare Services Division and the
Information Systems Division.
a. Estimate the divisional cost of capital for each of
Southeastern’s divisions assuming that both
divisions have the same optimal (target) capital structure. (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
division.)

b. Southeastern’s 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 differences. What
would be the short-term and long-
term consequences of Southeastern using a single 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 capacity for debt
financing than the other (perhaps due to
higher asset value and profitability.) How could different 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 answer to
Question 4a and the data in Table 18.3,
estimate the cost of capital for the homecare division of an
average not-for-profit hospital. How much
confidence do you have in the cost of capital estimate? Why?
6. One of Southeastern’s directors has expressed concern over
the difference between the company’s
target capital structure and the current structure as reported on

the balance sheet.
a. What are the book values of Southeastern’s long-term debt
and equity? What are the current
market values of Southeastern’s long-term debt and equity?
b. What are Southeastern’s 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 the corporate cost of
capital estimate? Why?
7. In your opinion, what are three key learning points from this
case?

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