Question

Assume that you have been asked to place a value on the acquisition of Briarwood Hospital. Its projected profit and loss statements and retention requirements are shown below (in millions):

				Year 1	Year 2	Year 3	Year 4	Year 5
Net revenues				$225.0	$240.0	$250.0	$260.0	$275.0
Cash expenses				$200.0	$205.0	$210.0	$215.0	$225.0
Depreciation				$11.0	$12.0	$13.0	$14.0	$15.0
Earnings before interest and taxes				$14.0	$23.0	$27.0	$31.0	$35.0
Interest				$8.0	$9.0	$9.0	$10.0	$10.0
Earnings before taxes				$6.0	$14.0	$18.0	$21.0	$25.0
Taxes (30 percent)				$1.80	$4.20	$5.40	$6.30	$7.50
Net profit				$4.2	$9.8	$12.6	$14.7	$17.5

Briarwood's cost of equity is 16 percent, its cost of debt is 10 percent, and its optimal capital structure is 40 percent debt and 60 percent equity. The best estimate for Briarwood's long-term growth rate is 4 percent. Furthermore, the hospital currently has $80 million in debt outstanding. What is the value of the hospital using the free cash flow method?

Answer 1

Solution:

a)Briarwood's WACC is;

=Cost of equity*% of Equity+Cost of debt(1-tax rate)*% Debt

=16%*0.60+10%(1-0.30)*0.40

=12.40%

b)Free cash flow(FCF) for year 1 to 5

Year	1	2	3	4	5
EBIT(1-tax rate)	$9.80	$16.10	$18.90	$21.70	$24.50
Add:depreciation	$11	$12	$13	$14	$15
Free cash flow	$20.80	$28.10	$31.90	$35.70	$39.50

FCF for 6th year=FCF for 5th year(1+growth rate)

=$39.50(1+0.04)=$41.08

Terminal value(value at the end of 5th year of future FCF)=FCF for 6th year/(WACC-Growth rate)

=$41.08/(12.40%-4%)

=$489.04762 million

Now,value of the hospital using the free cash flow method is;

=Present value of free cash flow till 5th year+Present value of terminal value

=$20.80/(1+0.124)^1+$28.10/(1+0.124)^2+$31.90/(1+0.124)^3+$35.70/(1+0.124)^4+($39.50+489.04762)/(1+0.124)^5

=$380.19 million