Subject: Business    / Finance
Question

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 (FOCF) 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?

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