What is the equity value of the HMO using the Free Operating Cash Flow (FCOF) method?

copy-of-chapter16.xls

Problem 2

	UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
		Chapter 16 -- Business Valuation, Mergers, and Acquisitions
PROBLEM 2
Assume that you have been asked to place a value on the fund capital (equity) of BestHealth, a not-for-profit
HMO. 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			$50.0	$52.0	$54.0	$57.0	$60.0
Cash expenses			$45.0	$46.0	$47.0	$48.0	$49.0
Depreciation			$3.0	$3.0	$4.0	$4.0	$4.0
Interest			$1.5	$1.5	$2.0	$2.0	$2.5
Net profit			$0.5	$1.5	$1.0	$3.0	$4.5
Estimated retentions			$1.0	$1.0	$1.0	$1.0	$1.0
The cost of equity of similar for-profit HMO's is 14 percent, while BestHealth's cost of debt is 5 percent.
Its current capital structure is 60 percent debt and 40 percent equity. The best estimate for BestHealth's
long-term growth rate is 5 percent. Furthermore, the HMO currently has $30 million in debt outstanding.
a. What is the equity value of the HMO using the Free Operating Cash Flow (FCOF) method?
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 according to the FOCF method?
ANSWER