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Problem 1, Financial Management

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You work for a small, for-profit health system. Your system is interested in acquiring a Critical Access Hospital (CAH) at a price of $65,000,000. The purchase would be made from retained earnings but your organization’s traditional cost of capital is 7%. Based on sophisticated financial forecasting models you expect the CAH to generate $3,900,000 in profit annually for 30 years. Given your system’s cost of capital (7%), this investment would lose money. However, one of your colleagues has suggested that due to subsidized Medicare reimbursement, the CAH revenues will be less risky and may help the system diversify.

Use CAPM with the historical data on system and CAH quarterly profits to estimate the appropriate discount rate assuming that the risk-free cost of capital is 3%.

Question

Is this a wise investment?

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