Question

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 barely profitable and had paid an average of only 20 percent in taxes during the last several years. In addition, it uses little debt, having a debt ratio of just 25 percent. 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 percent. HCA also would increase the debt capitalization in the Mission Health subsidiary to 40 percent of assets, which would increase its beta to 1.50. 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 Equity holders
1		$1.30
2		$1.50
3		$1.75
4		$2.00
5 and beyond		Constant growth at 6%

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

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

Answer :

Addressed in the Problem -

Cost of Equity (COE ) IS = 14%

Beta (B) IS = 1.0

Cost of debt (COD) IS = 10%

Risk free rate (RFR) IS = 8%

Presently, the COE to prepare the Market Risk Premium among the resulting formula -  

COE = RFR + Market Risk Premium x B

= 14 = 8 + Market Risk Premium x 1

= Market Risk Premium = 6

Revised COE IS = 8 + 6 x 1.50 = 17%

A. Discount rate used to discount the estimated cash flows IS = weighted normal value of assets

= 0.4 x 10 x ( 1 - 0.35) + 0.6 x 17

= 12.8%

b. Dollar value of Mission Health to HCA's shareholders is given below :

FCFF for year 5

= 2 x 1.06

= 2.12

Terminal value = FCFF for year 5 / ( WACC - increment rate )

= 2.12 / ( 0.128 - 0.06)

= 31.18

Present worth of amount goes will be -  

Present worth of amount runs from year 1 to 4 + Present value of terminal value

hence , 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