California Clinics

HSA 525

California Clinics

California Clinics, an investor-owned chain of ambulatory care clinics, just paid a dividend of $2 per share. The firm’s dividend is expected to grow at a constant rate of 5% per year, and investors require a 15 % rate of return on the stock.

Stock valuation based on earnings starts out with an assumption that each dollar of earnings per share of a company is really worth one actual dollar of income to the stockholder. To find the value of a stock, calculation of all future earnings needs to be done, to infinity, and then use own desired rate of return as a discount rate to find their present value. The infinite sum of these present values is the fair market value of the stock; or more accurately, it’s the maximum price you should be willing to pay.

The following will show what the California Clinics stock value is using a constant growth stock valuation. A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the foreseeable future. Some use “constant growth forever” case, meaning N is infinity. The formula in this case simplifies to:

$2.00 Do Last dividened payment

5% E(g) Expected growth rate

15% R(Rs) Required rate of return

$21 $200*.05/.15-.05 = 21

In a second scenario, supposing the riskiness of the stock decreases, which causes the required rate of return to fall to 13%, the stock value under these conditions would be as follows.

$2.00 Do Last dividend payment

5% E(g) Expected growth rate

13% R(Rs) Required rate of return

26.25 Yet, changing the variables once again returning to the original 15% required rate of return and assume a dividend growth rate estimate increase to 7% per year, $25 is now the stock value.

$2.00 Do Last dividened payment

7% E(g) Expected growth rate

15% R(Rs) Required rate of return

26.75 The following will explain how each of the four (4) fundamental factors that affect the supply and demand for investment capital, and hence, interest rates, (namely productive opportunities, time preferences for consumption, risk, and inflation) affects the cost of money. Economics is the study of production, distribution and consumption of goods and services whether in a city, country or a single business. Supply and demand is a fundamental factor in shaping the character of the market-place; it is understood as the principal determinant in establishing the cost of goods and services. The availability, of goods or services is a key consideration in determining the price at which those goods or services can be obtained.

For example, a landscaping company with little competition that operates in an area of high demand for such services will be able to command a higher price than will a business operating in a highly competitive environment. But availability is only one-half of the equation that determines pricing structures in the marketplace. The other half is “demand.” A company may be able to produce huge quantities of a product at low cost, but if there is little or no demand for that product in the marketplace, the company will be forced to sell units at a very low price. Conversely, if the marketplace proves receptive to the product that is being sold, the company can establish a higher unit price. “Supply” and “demand,” then, are closely inter-twined economic concepts.

Risk aversion is so important to financial decision making. It not only affects dollar and delivery of service or product, but also profit margin. Risk aversion is the tendency of investors to avoid risky investments. Thus, if two investments offer the same expected yield but have different risk characteristics, investors will choose the one with the lowest variability in returns. If investors are risk averse, higher-risk investments must offer higher expected yields. Otherwise, they will not be competitive with the less risky investments. In turn a so-called “rational” decision is choosing the option with the highest expected value. However, such a rational decision is what consumers should choose rather than what they would choose. The rational decision requires consumers to be risk neutral, which is obviously not realistic. People choose the option with the lower expected value rather than the one with the highest expected value.

Furthermore to better understand the following time value must be understood in or to explain the three techniques for solving time value problems. The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The old adage “time is money” is an important concept in financial markets. The three techniques are regular, ordinary and perpetuity annuity.

A simplistic way of expressing the distinction is to say that payments made under an ordinary annuity occur at the end of the period while payments made under an annuity due occur at the beginning of the period. Most annuities are ordinary annuities. Installment loans and coupon bearing bonds are examples of ordinary annuities. Rent payments, which are typically due on the day commencing with the rental period, are an example of an annuity-due. Thus, the present value or future value of an annuity due is always higher than that of ordinary annuity.

Annuity due = Ordinary annuity value ´ (1 + i)

Perpetuity starts as an ordinary annuity but has no end and continues indefinitely with level, sequential payments. Therefore, a perpetuity paying $1,000 annually at an interest rate of 8% would be worth:

PV = A/r = ($1000)/0.08 = $12,500

References

Ehrhardt, M. C., & Brigham, E. F. (2009). Corporate Finance: A Focused Approach. Mason,

Ohio: Cengage Learning.

Gapenski, L. C. (2008). Healthcare Finance: An Introduction to Accounting and Financial

Management (4th ed.). United States: Health Administration Press.