Medical Associates Essay

646 WordsMar 6, 20123 Pages
Medical Associates is a large for-profit group practice. Its dividends are expected to grow at a constant rate of 7% per year into the foreseeable future. The firm’s last dividend (D0) was \$2, and its current stock price is \$23. The firm’s beta coefficient is 1.6; the rate of return on 20 year T-bonds currently is 9%; the expected rate of return is 13%. The firm’s target capital structure calls for 50% debt financing, the interest rate required on the business’s new debt is 10% and its tax rate of 40%. 1- Calculate Medical Associates’ cost of equity estimate using the DCF method. The cost of equity is the rate of return that investors require on the firm’s common stock. Earnings can be paid in the form of dividends or retained for reinvestment in the business. The discounted cash flow (DCF) model E(Re)= D0 x [1 + E(g)] + E(g) = E(D1)/Po + E(g) D0 is \$2 x 1+7%= \$2 x 1.07 = \$2.14 Current Stock price is \$23 (Po) R(Re)= E(D1)/P0 + E(g) =2.14/23 + 7%= 16.30% 2- Calculate the cost of equity estimate using CAPM R(Re)= RF + [R(Rm)- RF] x b = RF + (RPm x b) = 9% + (13% - 9% ) x 1.6 = 9% + (4% x 1.6) = 9% + 6.4%= 15.40% 3- On the basis of your answers to #1 & #2, what is the final estimate of the firm’s cost of equity. Cost of equity is the rate of return that investors require on the firm’s common stock. The answer is 15.40% the CAPM is correct because it best describes the risk/return choices of stock investors. 4-The corporate cost of capital represents the cost of each new dollar of capital raised, rather than the average cost of all the dollars raised in the past. CCC = [Wd x R(Rd) x (1 – T)] + [We x R(Re)] Target capital of 50% with before tax rate of 10% the tax rate is 40%, T and the cost of equity is 15.40 %, = [0.50 x 10% x (1 – 0.40)] + [0.50 x 15.40%] = 15.70% 5- Describe the four (4) steps of capital budgeting analysis. 1-