Question

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HCA HealthCare is considering an acquisition of Mission Health. Mission Health is a publicly traded company, and its current beta is 1.30. Mission Health has been barley profitable and had paid an average of only 20% in taxes during the last several years. In addition, it uses little debt, having a debt ration of just 25%. If the acquisition were made, HCA would operate Mission Health as a separate, wholly owned subsidiary. Mission Health would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35%. HCA also would increase the debt capitalization in the Mission Health subsidiary to 40% of assets, which would increase its beta to 1.5. HCA estimates that Mission Health, if acquired, would produce the following net cash flows to HCA's shareholders (in millions of dollars):

Year		Free Cash Flows to Equityholders
1		$1.30
2		$1.50
3		$1.75
4		$2.00
5+		constant growth rate at 6%

These cash flows include all acquisition effects. HCA's cost of equity is 14%; its beta is 1.0; and its cost of debt is 10%. The risk free rate is 8%

A. What discount rate should be used to discount the estimated cash flow? (Hint: Use HCA's cost of equity to determine the market risk premium)

B. What is the dollar value of Mission Health to HCA's shareholders?

Answer 1

These cash flows include all acquisition effects. HCA's cost of equity(coe) is 14%; its beta is 1.0; and its cost of debt is 10%. The risk free rate is 8%
A. discount rate should be used to discount the estimated cash flow? (Hint: Use HCA's (COE)cost of equity to determine the market risk premium)
HCA coe is 14
coe = risk free rate + business danger premium x beta
14 = 8 + MRPx1
MRP = 6
Price of assets for Mission health = 8 + 6 x 1.50 = 17%
the percentage rate used to discount the cash flows = weighted normal value of assets
=0.4x 10 x ( 1 - 0.35) + 0.6x17
= 12.80% .

B.The dollar value of Mission Health to HCA's shareholders
FCFF for year 5 = 2x1.06 = 2.12
Pv of cash flows = pv of cash flows from year 1 to 4 + pv of terminal value
terminal value = FCFF for year 5 / ( wacc - growth rate )
= 2.12 / ( 0.128 -0.06) = 31.18
Dollar value of Mission Health to HCA's shareholders is 1.3 /1.128 + 1.5/1.128^2 + 1.75/1.128^3 + 2/1.128^4 + 31.18/1.128^4
= 24.05 m