Health Development Corporation

Case 2: Health Development Corporation HBS 9-200-049

1. Did the purchase of the Lexington Club real estate increase the value of Heatlh Development Corporation (HDC)? Calculate the NPV of the purchase.

• Use pre-tax cashflows.

• Assume the revenues of the Lexington Club grow by 5% per year.

• Assume that the appropriate discount rate for real estate cashflows was 10%.

• Assume a 20 year life of the facility.

(Hint: In calculating the NPV of the decision to buy the real estate, you only need to consider the incremental cashflows resulting from the decision).

NPV=

=11203677.75 – 6,500,00

= $4,703,677.75

Assumptions:

• The change in incremental cash flow can be examined through looking at the factors causing change in operating income – in this case only the lease cost is different.

• The interest repayments are a cost of capital, rather than a cost of operating, and are accounted for in the $6.5 million as a perpetuity outflow of $504,000 giving a present value of $5,750,000. They are therefore not included in the incremental cash flows.

2. TSI values HDC as (5 x EBITDA - debt). Exhibit 3 of the case shows TSI’s valuation of HDC, using EBITDA projected for year 2000, both with ownership of the property and leasing of the property. Explain, in just a few bullet points, the $1.875 million difference in valuations (don’t put any tables in your answer).

• EBITDA for owning Lexington is larger by $925k, the amount of the lease (EBITDA does not count cost of interest and depreciation, but includes cost of lease)

• 5x of that is $4,625k

• The other difference between owning and leasing is amount used to buy Lexington, $6,500k

• 5x - debt is valuation difference. Multiplication of 5 has massive effects on the valuations, the assumption is that a multiplier of 5 reflects an approximate valuation to the present value of the cash flows.

HDC decides to restructure the ownership of the Lexington club to get around the real estate problem that TSI’s valuation method creates. The deal is as follows:

• A holding company, named ABC, is created to own the Lexington Club and lease it back to HDC. The holding company is owned by the shareholders of HDC.

• HDC is then sold to TSI for an amount $X (which equals TSI’s valuation of HDC in this agreement).

• The agreement to sell HDC to TSI includes the sale of the Lexington Club by HDC to ABC for $6.5 million.