Medical Associates Is a Large For-Profit Group

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 is 40%.

You are to write a report that answers the following:

Calculate Medical Associates' cost of equity estimate using the DCF method.

Next years expected dividend = $2 * 1.07 = 2.14

Current Stock Price = $

E (Rc) = 2.14/23 + .07 = .1630 = 16.3%

Calculate the cost of equity estimate using CAPM.

R (Rc) = .09 + (1.6 * .013) = .1108 = 11.1%

On the basis of your answers to #1 & #2, what is your final estimate for the firm's cost of equity?

The two approaches have produced what can be considered a range for the actual cost of equity. A more accurate estimate would be the mean of the two numbers which is 13.7%.

3. Calculate the firm's estimate for corporate cost of capital.

CCC = (.5 * .137) * (1-.4) + (.5 * .163)

CCC = .0411 + .0815

CCC = .1226 = 12.26%

4. Describe the four (4) steps of capital budgeting analysis.

1) Cash flow estimation phase -- the capital outlay, operating cash flows, and terminal cash flows must be estimated; basically a summary of all the capital that will be required and when it will be spent.

2) Project riskiness -- the risks involved the project must be weighed based on the probability of success.

3) The project cost of capital is assessed -- the firm's average risk is generally used to provide a premium over the risk free rate.

4) Financial attractiveness -- financial information can be plugged into different models such as the breakeven analysis or net present value to determine what the project might look like to an investor.

5. Describe how is project risk is incorporated into a capital budgeting analysis.