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solution

Medical Associates is a large for-profit group practice. Its dividends are expected to grow at a constant rate of 7 percent 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 percent; and the expected rate of return on the market, as reported by a large financial services firm, is 13 percent. The firm’s target capital structure calls for 50 percent debt financing, the interest rate required on the business’s new debt is 10 percent, and its tax rate is 40 percent.

a. What is Medical Associates’s cost of equity estimate according to the DCF method?

b. What is the cost of equity estimate according to the CAPM?

c. On the basis of your answers to Parts a and b, what would be your final estimate for the firm’s cost of equity?

d. What is your estimate for the firm’s corporate cost of capital?

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