Question

A relatively small medical group practice is trying to estimate its corporate cost of capital. The practice is 100 percent equity financed. The rate of return on 20-year Treasury bonds is currently 6 percent, and the expected rate of return on the market is 12 percent. A large practice management firm has a beta coefficient of 0.9. Market research indicates that the cost of equity for very small firms is approximately 4 percentage points higher than the cost of equity for large firms. Moreover, the investors in the small group practice face liquidity risk and thus determine that a liquidity premium of 2 percentage points is appropriate.

a. What is the best estimate of the firm's corporate cost of capital?

b. How would your estimate of the corporate cost of capital change if the success of the medical group practice was highly dependent on the reputation of a single physician in the group?

PLEASE SHOW ALL WORK. THANK YOU!

Answer 1

a). Cost of equity for the large practice management firm = risk-free rate + beta*(market return - risk-free rate)

= 6% + 0.9*(12%-6%) = 11.40%

Cost of equity for small practice firms is 4% higher and investors also require a liquidity premium of 2%, so cost of equity for the small medical group practice will be

11.40% + 4% + 2% = 17.40%

b). If the group's practice is highly dependent on the reputation of a single physician in the group then the risk increases so cost of equity will go up, if that is the case.