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Morningside nursing home, a not-for profit corporation, is estimating its corporate cost of...

Question:

Morningside nursing home, a not-for profit corporation, is estimating its corporate cost of capital. Its tax-exempt debt currently requires an interest rate of 6.2 percent and its target capital structure call for 60 percent debt financing and 40 percent equity (fund capital) financing. The estimate cost of equity for selected investor-owned health care companies are given below:

ABC 15.0%

BCD 16.4

CDE 17.4

DEF 18.8

A.) What is the best estimate for Morningside's cost of equity?

B.) What is the firm's corporate cost of capital?

Cost of Capital & Cost of Equity

The cost of equity is the required rate of return demanded by investors given the riskiness of a security or financial asset. The cost of capital is the weighted average of the individual component costs where weights are the proportion of debt and equity in the balance sheet.

Answer and Explanation:

A) Given the above information about Morningside Nursing Home, we can determine the cost of equity by averaging other selected investor-owned health care companies.

ABC 15.0%
BCD 16.4
CDE 17.4
DEF 18.8
Average 67.60/4 = 16.90%

Therefore, the best estimate for Morningside's cost of equity is the arithmetic average of other selected investor-owned health care companies which is 16.90%.

B) Cost of Capital:

{eq}WACC = W_D*K_D*(1-T)+W_E*K_E {/eq}

{eq}WACC = 0.60*0.062+0.40*0.1690 {/eq}

{eq}WACC = 10.48\% {/eq}

Therefore, the weighted average cost of capital is 10.48%.


Learn more about this topic:

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Required Return vs. Cost of Capital

from Finance 101: Principles of Finance

Chapter 14 / Lesson 1
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