Gold Coast Homecare Cost of Capital

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Gold Coast HomecareCost of Capital
Mabelissa Acevedo Pat Foran
Du Nguyen Jim Shaffer
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Gold Coast Background

• Founded in 1982 in Miami, FL as a taxable
  partnership
• Objective to provide in-home care by
  physicians, nurses, physical therapists
• Early success spawned rapid growth and increased
  capital requirements

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Gold Coast Background

• Founders exhausted personal resources
• Incorporated in 1992 sold common stock through an
  IPO in 1995
• 1998 One of the 100 best managed small companies
  in the US

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Gold Coast Background

• Two Divisions
• Healthcare Services
• Homecare services in 22 locations
• Information Services
• Proprietary software for operations management

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Statistics According to the National Association
for Home Care

• Approximately 7.6 million people in the US
  require some form of home health care.
• More than 20,000 home health care providers exist
  today.
• Almost two-thirds (62.3 percent) of home health
  care recipients are women.
• More than two-thirds (68.6 percent) of home
  health care recipients are over age 65.

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Statistics According to the National Association
for Home Care

• Conditions requiring home health care most
  frequently include diabetes, heart failure,
  chronic ulcer of the skin, osteoarthritis, and
  hypertension.
• Approximately 41.3 billion dollars was projected
  to be spent on home health care in 2001.
• Medicare is the largest single payer of home care
  services.
• In 1999, Medicare spending was approximately 26
  percent of the total home health care expenditure.

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Impact of Recent Change on Gold Coast

• Rapid random growth without formal decision
  structures was possible until market competition
  increased and reimbursement for home health
  services declined
• Board of Directors mandated that corporate
  managerial practices be refined
• To remain competitive, Gold Coasts optimum
  capital structure must be determined

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Gold Coasts Capital Structure

• Cost of Debt Capital Estimation
• Cost of Equity Capital Estimation 3 Models -
  (CAPM), (DCF) and Debt Cost Plus Risk
• Target Capital Structure
• Actual Capital Structure
• Comparison with Not For Profit CCC
• Marginal Costs
• Divisional Costs
• Conclusions

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Cost of Debt Capital Estimation
After-tax cost of debt R(Rd) x (1-T)
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Cost of Equity Capital Estimation Capital Asset
Pricing Model (CAPM)

• Gold Coast's Cost of Equity ranges from 12.7 -
  14.1
• 0.7 - 2.1 higher than an average company's
  Required Rate of Return of 12
• Assuming that recent market changes are making
  Gold Coasts a higher risk stock than its
  historic 1.1 to 1.3 range, we selected the higher
  risk beta of 1.3, for a CAPM cost of equity of
  14.1

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Cost of Equity Capital Estimation Discounted Cash
Flow (DCF) Approach
Annual growth rate ranges between 8 -12

• Based on DCF Approach, the cost of equity is 14
  
• Close to 14.1 estimated from the CAPM

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Cost of Equity Capital Estimation Debt Cost Plus
Risk Premium Approach
Average Firm Risk Premium Cost of Equity - Cost
of Debt 12 - 7.0 5

• Weakness of this approach is that there is no
  assurance that the Gold Coasts risk premium is
  the same as the average firm

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Comparison of the Three Methods and Final Cost
of Equity Estimate

• Cost of Equity Capital Estimation
• Capital Asset Pricing Model (CAPM) 14.1
• Discounted Cash Flow (DCF) Approach 14.0
• Debt Cost Plus Risk Premium Approach 13.0

CAPM and DCF are more consistent

• Final Estimate for Cost of Equity is 14.0

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Gold Coasts Target Capital Structure
Final Estimate for Gold Coasts CCC

• 10.8 CCC will be the benchmark capital
  budgeting hurdle rate
• Minimum return necessary for a average risk
  project to be attractive financially to Gold Coast

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Gold Coasts Actual Capital Structure
Gold Coasts Actual CCC

• The debt to equity ratios are only 15 off the
  target and have probably not yet resulted in a
  severe interest rate penalty on debt.
• Book values are used in order to avoid drastic
  market swings.
• Market value of stock is now 50 million versus
  20.3 million on the balance sheet.

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Average Non-For-Profit Long Term Capital
Structure

• A NFPs CCC is only drastically lower if it
  views itself as not having to meet market rates
  of return. This is a delusion that can only be
  maintained in the short run.

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Marginal Cost of New Debt

• Before-tax cost of debt R(Rd) 8
• New debt issue will be 30 years versus
  15. T-Bond 15 4.7 T-Bond 30 5.1
• Proportional risk results in a 8.7 rate for the
  new 30 year bond issue.
• The marginal cost might be even higher if the
  debt/equity ratios move much beyond 50.
• The call provision might also be increasing the
  cost of debt by a small due to its creation of
  a cap on earnings if interests rates drop.

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Marginal Cost of New Equity

• The Cost of Equity for new (marginal) retained
  earnings equals that of existing retained
  earnings.
• If Gold Coast cannot match or exceed its cost of
  capital of 14 for new projects it should pay out
  retained earnings in dividends.
• The Cost of Equity for a new stock issue is
  substantially higher than using retained
  earnings.
• With 30 floatation costs, the marginal cost of
  equity is 14/.7 20.
• This 6 differential explains the preference for
  use of retained earnings to increase equity
  compared to new stock issues.

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Divisional Cost of Capital Considerations

• 60 of Gold Coasts operating assets are used by
  Healthcare Services Division
• Best estimate for this divisions risk is a beta
  1.0
• 40 of Gold Coasts operating assets are used by
  the the Information Services Division
• Higher risk divisionGold Coast has a 1.3 beta
• Gold Coast Overall beta is 1.3, HSDs 60 is 1.0
• Resulting in a ISD Beta of 1.75
• This corresponds closely to the high betas for
  two practice management companies in table 13.3
  Phycor 1.75 and US Oncology 1.98.

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Divisional Cost of Capital Considerations

• If you separate the two divisions cost of capital
  you get vastly different debt and equity costs
• This is why business analysts advocate against
  conglomerates and holding companies owning
  companies which are in very different businesses.
  

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Conclusions

• The NFP Threat is real but their finance
  structure does not give them an overwhelming
  advantage
• New equity should come from retained earnings
• New debt issues will be higher cost and should
  not be out of proportion with increases in equity
  to retained earnings.
• The Divisions should recognize that they have
  different starting benchmarks for deciding what
  new projects to undertake.
• The crossover synergies of the two divisions
  should be evaluated to see if it might make sense
  to spin off the ISD

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Questions?