HCA 2006

Full Firm Valuation: Deal Financing

Practice Case

Overview

You will be assisting Taylor Murphy in determining if her group of bidders can justify topping the $51 per share offer for HCA from the management-led consortium. Your valuation should take place as of December 31 2006 which will be the time any potential takeover could be closed. As a result, your valuation should be based on the projected free cash flows starting in 2007. The forecasts for year end 2006 numbers given in Exhibits 3 and 5 (denoted “2006E”) should be treated as the best possible approximations for the actual final balance sheet and income statement for 2006.

Assignment Questions

1. Project HCA’s free cash flows. Base your projections on management’s forecasts given in Exhibit 5 for the years 2007-2011. You should project free cash flows beyond 2011 until the steady state is reached (i.e. when estimated FCF growth becomes constant going forward). To do this, use the following information:

 Revenue: After 2011, revenue growth is expected to average 4.5% annually into the foreseeable future.

 Other Operating Income The forecasts in Exhibit 5 include “Other Operating Income” which refers to income (net of expenses) generated from HCA’s operations that are not related directly to patient care such as hospital cafeteria sales, hospital gift shop sales, medical research grants and hospital parking garage fees. In the historical income statements given in Exhibit 2 this income is included as part of “Revenue”.

 Operating Margins: By 2011, operating margins will have reached their steady-state, long run levels. That is, EBIT will grow at the same rate as revenue after 2011.

 Tax Rate: HCA will face a tax rate of 37.5%.

 Non-Operating Income (net): In Exhibit 2 and Exhibit 5 “non-operating income (net)” refers to interest income and gains and losses related to HCA’s investments in cash and cash equivalents.

 Net Property Plant and Equipment: After 2011 Net Property Plant and Equipment is expected to grow at the same rate as revenue.

 Other Current Assets: Included in the balance sheet information in Exhibit 3 are “Other Current Assets”. These refer to HCA’s Prepaid Expenses.

 Amortization of Fees: For tax purposes the $910M banking “Fees and Expenses” (see Exhibit 7) as well as the $300M breakup fee will be amortized straight line over four years starting in 2007. These fees will be incurred at the time of the deal: December 31 2006. This projected amortization is not included in the projections in Exhibit 5. Recall that for the purposes of calculating free cash flow that amortization should be treated in the same way as depreciation (it is a non-cash expense but does generate a tax shield).

 Working Capital: The “Increase in Working Capital” in Exhibit 5 refers to the change from the previous year in the level of working capital where working capital is defined as:

Working Capital = Accounts Receivable + Inventory + Other Current Assets – Accounts Payable – Accrued Expenses

Note that this definition of working capital is incomplete because it does not include the reduction in the deferred tax liability (“reduction in deferred taxes”) that are listed separately in Exhibit 5 and relate to projected changes in the deferred income tax liability (“deferred income taxes”) on the balance sheet in Exhibit 3. You should think carefully about whether a reduction in a deferred tax liability represents an increase or a decrease to free cash flow when incorporating it in your forecasts. Beyond 2011 all items in working capital (i.e. including the level of deferred income taxes) are expected to grow at the same rate as revenue.

2. Estimate HCA’s optimal capital structure. Note that the proposed capital structure to finance the deal (Exhibit 7) might not be the optimal capital structure for HCA going forward. You expect that HCA will move towards the optimal capital structure going forward. Estimate what ND*/EV should be optimally for HCA. To do this, use the following information:

 The current proposed offer of $33,310M is an offer to buy all the equity AND debt of HCA. Put differently, it represents how much the buying group is prepared to pay to acquire all of the assets of the firm (Enterprise value and Cash). Use this information to form. your initial estimate of the enterprise value of HCA for your OCS calculations.

 When estimating the OPMRWC you should take into account how management’s forecasts of future operating profit margins (from Exhibit 5) compare to the margins that have been obtained over the last 10 years. If you are expecting margins to be higher or lower on average in the future than the minimum OPM that has been realized historically should be adjusted accordingly to forecast what OPMRWC is likely to be in the future. Use your own judgement in deciding how to do this and justify the choice you make. There is no one “right” way to do this.

 You will need to estimate the yield that HCA will pay on its debt (rD) at the optimal capital structure. To do this use the information on debt ratings and yields in Exhibit 9 and 11. Specifically, estimate HCA’s bond rating by computing the actual coverage ratio HCA would have had in 2006 if it had been at its optimal capital structure. Compare this to the information on “EBIT Interest Coverage (x)” in Exhibit 11 to estimate how HCA will be rated in the future.

Justify each of the judgments you make in arriving at your estimate for the optimal capital structure.

3. Estimate the weighted average cost of capital. You should estimate the WACC for HCA at the optimal capital structure. Choose comparable firms from those listed in Exhibit 10 to estimate the asset beta for HCA. Information on HCA’s own equity beta is not included in the case. Justify your choice of comparable firms. Assume that there are no non-operating assets at these comparable firms.

4. Estimate HCA’s residual value. You should estimate two different residual values for HCA:

 Growing Perpetuity Assume that the free cash flows grow at a constant rate consistent with your forecasts. To do this you will need to find the year when, according to your forecasts the free cash flows begin to behave like a growing perpetuity (i.e. grow from that year forward at a constant rate).

 Enterprise Value/EBIT Multiple Estimate the residual value using a EV/EBIT multiple based on comparable firms (in Exhibit 10). Justify which firms you use for your analysis. Do this to form. an estimate of the residual value at the same point in time as the other two residual value estimates. Hint: when applying this method the data in Exhibit 10 will produce a trailing multiple (Enterprise Value in year t divided by EBITt). In words they will give you an estimate of the enterprise value at a point in time as a multiple of the level of EBIT in the year leading up to that point in time. You should apply the multiple you get from these comparables to HCA’s forecasted EBIT in a consistent way. Refer to Lecture 9 if you need a refresher on this.

5. Valuation and Recommendation. Using each of the two residual values, estimate the value of the firm and the value of HCA’s equity. What is the share price implied by each valuation? Would you recommend that Roary make a bid for HCA above the current offer of $51 per share? Explain.