assignment 6.0

Chapter 21

Capital Formation

Learning Objectives

1. Explain the differences between debt and

equity financing and the sources of each.

2.Explain the factors that influence the

desirability of alternative sources of

financing.

3.Explain what an investment banker does.

4.List the major bond rating agencies and

explain their role in the debt market.

5.List some of the pros and cons of retiring

debt early.

Two Key Questions

These questions will inform our discussion

of capital formation in the healthcare

industry:

1. How much capital is needed?

2. What sources of capital financing are

available?

1. How much capital is needed?

2. What sources of capital are available?

Two Key Questions, cont.

Distribution in Hospitals

How is the financing structure changing?

Courtesy of Cleverley & Associates

Three Ways to Generate

New Equity Capital

1. Profit retention: using net income to increase

equity (topic discussed extensively in GRIE

discussions)

2. Contributions: using philanthropic gifts to

increase equity

3. Sale of equity interests: using the issuance

of new ownership interest to increase equity

Contributions/Philanthropy

Giving USA 2016: The Annual Report on Philanthropy for the Year 2015. Researched and written by Indiana University Lilly Fami ly School of

Philanthropy.

Contributions/Philanthrop,

cont.

Giving USA 2016: The Annual Report on Philanthropy for the Year 2015. Researched

and written by Indiana University Lilly Family School of Philanthropy.

Contributions/Philanthrop,

cont. • KEYS TO SUCCESS

1. Case statement: Defines why you need money

2. Designated development officer: Does not need to

be full-time; incentives should relate to giving

expectations

3. Trustee and medical staff involvement: People give

to people, not to organizations

4. Prospect lists: Know who in the community are prime

prospects for giving

5. Programs for giving: Variety of methods and means

to encourage giving

6. Goals: Define realistic targets for long-range planning

Issuance of Equity

• Taxable firms have relied heavily on equity

issuance to raise capital for years

• Interest in not-for-profit firms has been

generated by raising capital through using

restructured organizations and taxable

entities to raise capital

(Example of not-for-profit organizational structure on

next slide)

Issuance of Equity, cont.

FIGURE 21-1 A Parent Holding Company

Long-Term Debt

Financing

• KEY CHARACTERISTICS

1. Cost

2. Control

3. Risk

4. Availability

5. Adequacy

Long-Term Debt

Financing, cont.

KEY CHARACTERISTICS

1. Cost

• Interest rates are the most important

characteristic that affects the cost of alternative

debt financing.

 Key term: coupon rate: fixed return of a long-term

debt instrument

 Key term: basis point: 1/100th of 1%

• Issuance costs are simply those expenditures

that are essential to consummate the financing

• Reserve requirements are sometimes

required; these are fund balances in

escrow accounts under the custody of the

bond trustee. There are two types of

reserves:

– Debt Service Reserve

– Depreciation Reserve

Long-Term Debt

Financing, cont.

Long-Term Debt

Financing, cont.

• KEY CHARACTERISTICS

2. Control: Investors often will specify some conditions or

restrictions that they would like included in the bond

contract; such conditions or restrictions are often known

as covenants. Covenant categories include:

 Financial performance indicators (such as current ratio)

 Future financing (additional parity financing defines

conditions to be met before firm can issue additional

debt)

– Key term: Indenture: the “debt contract” between the parties

Long-Term Debt

Financing, cont. KEY CHARACTERISTICS

3. Risk

• From the issuer’s perspective, flexibility of repayment

terms is highly desirable. The investor, however, wants

some guarantee that the principal will be repaid in

accordance with some pre-established plan.

 Prepayment provision: specifies the point in time at which

the debt can be retired, and the penalty imposed for an early

retirement

 Call premium: some percentage of the par or face value of

the bonds

Long-Term Debt

Financing, cont.

KEY CHARACTERISTICS

3. Risk (cont.)

• Debt principal amortization pattern:

 Level-debt service: the amount of interest and

principal that is repaid each year remains fairly

constant (e.g., most home mortgages)

 Level-debt principal: an equal amount of debt

principal is repaid each year. In this pattern of debt

retirement, the total debt service payment

decreases over time.

Long-Term Debt

Financing, cont.

FIGURE 21-3 Level-Debt Service: Relationship Between

Interest Payment and Debt Principal

Long-Term Debt

Financing, cont.

FIGURE 21-4 Level-Debt Service: Relationship Between Interest

Payment and Total Debt Principal

Long-Term Debt

Financing, cont.

KEY CHARACTERISTICS

4. Availability

• Once a healthcare firm decides that it needs

debt financing, it usually wants to obtain the

funds as quickly as possible. However, the

difference in interest rates may more than

offset the costs of delay.

Long-Term Debt

Financing, cont.

KEY CHARACTERISTICS

5. Adequacy

• A key requirement of any proposed plan of financing

is that it cover all the associated costs. One of the key

areas of adequacy is that of refinancing costs. In

many situations, a new construction program that

requires financing may not be possible unless existing

financing can be retired or refinanced. Not all types of

financing permit the issuer to include the costs of

refinancing in the amount borrowed.

Long-Term Debt

Financing Sources

SOURCES

1. Tax-exempt revenue bonds

• Permit the interest earned on them to be

exempt from federal income taxation

• The primary security for such loans is usually a

pledge of the revenues of the facility seeking

the loan, plus a first mortgage on the facility’s

assets.

• If the tax revenue of a government entity

is also pledged, the bonds are referred to

as “general obligation bonds.”

• Most tax-exempt revenue bonds are

issued by a state or local authority. The

healthcare facility then enters into a

lease arrangement with the authority.

Title to the assets remains with the

authority until the indebtedness is repaid.

Long-Term Debt

Financing Sources, cont.

SOURCES

2. Federal Housing Administration (FHA)-insured

mortgages

• FHA-insured mortgages are sponsored by the Federal

Housing Administration, but initial processing begins in

the Department of Health and Human Services.

• Through the FHA program, the government provides

mortgage insurance for both proprietary and

nonproprietary hospitals. This guarantee reduces the

risk of a loan to investors and thus lowers the interest

rate that a hospital must pay.

Long-term Debt

Financing Sources, cont.

SOURCES

3. Public Taxable Bonds

• Public taxable bonds are issued in much the

same way as tax-exempt revenue bonds,

except that there is no issuing authority and no

interest income tax exemption. An investment

banking firm usually underwrites the loan and

markets the issue to individual investors.

Interest rates are thus higher on this type of

financing than they are on a tax-exempt issue.

Long-term Debt

Financing Sources, cont.

SOURCES

4. Conventional Mortgage Financing

• Conventional mortgage financing is usually privately

placed with a bank, pension fund, savings and loan

institution, life insurance company, or real estate

investment trust. This source of financing can be

arranged quickly, but, compared with other

alternatives, does not provide as large a percentage of

the total financing requirements for large projects.

Thus, greater amounts of equity must be contributed.

Long-Term Debt

Financing Sources, cont.

FIGURE 21-5 Parties Involved in a Public Tax-Exempt

Revenue Bond Issue

Long-Term Debt

Financing: Bond-Rating

Agencies

• Bond ratings

 Primary agencies

– Moody’s – Standard and Poor’s – Fitch

Long-Term Debt Financing:

Recent Developments

1. Variable rate financing

2. Pooled or shared financing

3. Zero-coupon and original issue discount

bonds

4. Interest rate swaps

Long-term Debt Financing:

Early Retirement

• WHY?

1. Permits the issuer to take advantage of a

reduction in interest rates

2. Avoids onerous covenants in the existing

indenture

3. Takes advantage of changes in bond ratings

4. Takes advantage of changes in policy

regarding tax-exempt financing

Long-term Debt Financing:

Early Retirement, cont.

• TYPES OF EARLY ISSUE RETIREMENT

1. Refinancing: The issuer buys back the

outstanding bonds from the investors (two

ways):

a. Possible option of an early call

b. Buy back the bonds in open-market transactions or

send a letter to existing bondholders, offering to

buy the bonds at some stated dollar amount

2. Refunding: Outstanding bonds are not

acquired by the issuer, and the present

bondholders continue to maintain their

investment. The refunding does not actually

retire the bonds, but the bonds are not shown

on the issuer’s financial statements, and the

covenants present in the indenture are now

voided (a process called defeasance).

Long-term Debt Financing:

Early Retirement, cont.