Question

Assume that you have been asked to place a value on the fund capital (equity) of BestHealth, a not-for-profit health maintenance organization (HMO). Its projected profit and loss statements and equity reinvestment (asset) requirements are as follows:

	2016	2017	2018	2019	2020
Net Revenues	$50.00	$52.00	$54.00	$57.00	$60.00
Cash expenses	$45.00	$46.00	$47.00	$48.00	$49.00
Depreciation	$3.00	$3.00	$4.00	$4.00	$4.00
Interest	$1.50	$1.50	$2.00	$2.00	$2.50
Net Profit	$0.50	$1.50	$1.00	$3.00	$4.50
Asset Requirements	$0.40	$0.40	$0.40	$0.40	$0.40

The Cost of equity of similar for-profit HMOs is 14 percent, while the best estimate for BestHealth’s long-term growth rate is 5 percent.

a) What is the equity value of the HMO?

b) Suppose that it was not necessary to retain any of the operating income in the business. What impact would this change have on the equity value?

Answer 1

solution:

(a) Value of the Equity = Present value of the Free cash flows to equity (FCFE) + Present value of the terminal FCFE

Free cash flow to equity = Net profit + Non cash expenses(i.e Depreciation) - Capital Expenditure.

Year	2016	2017	2018	2019	2020
($Millions)
Net Profit	0.5	1.5	1	3	4.5
Add:Depreciation	3	3	4	4	4
Less: Capital Expenditure(Asset Requirememnts)	-0.4	-0.4	-0.4	-0.4	-0.4
FCFE ($ Millions)	3.1	4.1	4.6	6.6	8.1

Terminal or long term growth rate is(g) = 5% or 0.05

Cost of equity or K = 14% OR 0.14

Terminal FCFE at year end 2020 =

Hence FCFE at 2020 end =

Value of the Equity = Present value of the Free cash flows to equity (FCFE) + Present value of the terminal FCFE

Present value =

is also called Present value factor.

.	A	.	B	.	A*B
Year	Cash flow($Millions)		PVF@14%		PV of the cash flows
2016	3.1	FCFE	0.8771929825	=1/(1.14)^1	2.72
2017	4.1	FCFE	0.7694675285	=1/(1.14)^2	3.15
2018	4.6	FCFE	0.6749715162	=1/(1.14)^3	3.10
2019	6.6	FCFE	0.5920802774	=1/(1.14)^4	3.91
2020	8.1	FCFE	0.5193686644	=1/(1.14)^5	4.21
2020	94.50	Terminal value	0.5193686644	=1/(1.14)^5	49.08
.	.	.	.
.	.	.	.	Value of the equity($Millions)	66.17

hence the value of the equity = $66.17 Millions

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(b)

Growth = Return on equity * Retention ratio.

If Nothing of the operating income has been ratined , then the retention ratio = 0% and hence growth rate = 0%

if Growth rate =0 % then the Terminal value at the end of 2020 =

=>

Hence,

.	A	.	B	.	A*B
Year	Cash flow($Millions)		PVF@14%		PV of the cash flows
2016	3.1	FCFE	0.8771929825	=1/(1.14)^1	2.72
2017	4.1	FCFE	0.7694675285	=1/(1.14)^2	3.15
2018	4.6	FCFE	0.6749715162	=1/(1.14)^3	3.10
2019	6.6	FCFE	0.5920802774	=1/(1.14)^4	3.91
2020	8.1	FCFE	0.5193686644	=1/(1.14)^5	4.21
2020	57.86	Terminal value	0.5193686644	=1/(1.14)^5	30.05
.	.	.	.
.	.	.	.	Value of the equity($Millions)	47.14

hence if nothing is retained or if growth rate is 0% then the value of the equity will decrease to $47.14 Millions from $66.17 Millions.