Law Week 9 Assignment- Healthcare Finance

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CHAPTER 9 Cost of Capital

Providers of business capital have an expectation of earning a return on the funds provided; this expectation means that capital has a cost to businesses. With an estimate of this cost, managers can make better decisions regarding capital allocation—that is, which capital assets should be acquired.

Cost of Capital Basics

The corporate cost of capital is a blend (weighted average) of the costs of a business’s permanent financing sources.

It is used as a benchmark rate of return in the evaluation of proposed projects.

Key considerations:

Capital components to include

Handling of tax benefits (for FP businesses)

Historical versus marginal costs

Component Cost of Debt

Discuss debt costs with banker:

Investment banker if bonds are used

Commercial banker if loan is used

Look at YTM on outstanding bond issues if they are actively traded.

Look to the debt markets for guidance:

Interest rates on recent issues by companies that are similar

The prime rate

Component Cost of Debt (cont.)

For a not-for-profit organization, the cost of debt is the unadjusted interest rate on new debt.

For an investor-owned business, the cost of debt must be adjusted to consider the tax effects. Consider Valley Clinic:

Assume it has a 30 percent tax rate and a new bank loan would have an interest rate of 10 percent.

Its component (effective) cost of debt would be 10% x (1 – T) = 10% x 0.7 = 7.0%.

This adjustment will be built into the corporate cost of capital formula.

Component Cost of Debt (Cont.)

Issuance costs typically are small and hence can be ignored in the debt cost estimate.

Also, the difference between the stated rate and effective annual rate (EAR) is small, so the stated rate generally is used.

Does ownership (FP versus NFP) have a significant effect on the effective cost of debt?

Component Cost of Equity

The component cost of debt is the return required by debt suppliers; the component cost of equity is defined similarly.

For now, we will consider investor-owned businesses. (We will consider NFPs later.) The primary sources of equity are:

Retained earnings

New equity (common stock) sales

Component Cost of Equity (Cont.)

The cost of new common stock is the return that investors require on that stock.

The cost of retained earnings is based on the opportunity cost principle:

If earnings are retained rather than returned to owners, the owners bear an opportunity loss.

These funds, if returned to owners, could be reinvested in alternative investments of similar risk.

Component Cost of Equity (Cont.)

Thus, retained earnings have roughly the same cost as does new common stock.

There are three methods that can be used to estimate the cost of equity in a large, publicly traded for-profit business:

Capital Asset Pricing Model (CAPM)

Discounted cash flow (DCF) model

Debt cost plus risk premium model

CAPM Method

The Capital Asset Pricing Model (CAPM) is an equilibrium model that relates market risk to required rate of return.

The equation used is the Security Market Line (SML):

R(Re) = RF + [R(RM) - RF] x b

CAPM Method (cont.)

Where do we get the input values?

RF is the rate on T-bonds.

R(RM) can come from:

Brokerage house estimates

Historical data

Betas come from investment analysts and from proxy companies.

Which input is the “weak link” in the CAPM method?

Some Betas—Healthcare Sector

What do these values tell us?

Community Health Sy CYH Acute care hospitals 4.11

Tenet THC Acute care hospitals 2.18

DaVita Healthcare DVA Dialysis services 1.65

McKesson Corp MCK Medical supplies 1.54

HCA Healthcare Inc HCA Acute care facilities 1.27

Laboratory Corp LH Clinical laboratory 1.23

Universal Health Serv UHS Acute care facilities 1.21

Humana Inc HUM Managed care 1.02

Amgen AMGN Biotechnology 0.90

UnitedHealth Group UNH Managed care 0.89

Medtronic MDT Medical equipment 0.66

Pfizer PFE Pharmaceuticals 0.54

* Data obtained from Yahoo Finance on May 23, 2019

R(Re) = RF + [R(RM) - RF ] x b

= 6.0% + (7.0% x 1.14) = 14.0%.

CAPM Method (cont.)

What is Valley Clinic’s component cost of equity if RF = 6.0%, RPM = 7%, and Valley Clinic has a beta (market risk) of 1.14?

What does RPM stand for?

When working with the CAPM, which of the following factors can be determined with the most precision?

The market risk premium (RPM)

The beta coefficient, bi, of a relatively safe stock

The most appropriate risk-free rate, RF

The expected rate of return on the market, R(RM)

The beta coefficient of “the market,” which is the same as the beta of an average stock

Self-Check

DCF Method

The discounted cash flow (DCF) approach, which is applicable only to dividend-paying firms, assumes that a business’s stock price is the present value of the expected dividend stream.

The DCF method can be used both with constant and nonconstant growth, but the calculations are more complicated when growth is nonconstant.

DCF Method (cont.)

Under constant growth assumptions, the DCF model is expressed in its rate of return form as:

E(Re) = R(Re) = + E(g) .

E(D1)

DCF Method (cont.)

Where do we get the input values?

P0 comes from many hardcopy or online sources.

E(D1) can come from:

Analyst’s estimates.

Historical D0 multiplied by [1 +E(g)].

E(g) from stock analysts’ forecasts.

Which input is the “weak link” in the DCF method?

DCF Method (Cont.)

Assume that P0 = $40, E(D1) = $3.60, and E(g) = a constant 5.0% for Valley Clinic. Then,

R(Re) = + E(g) = + 5.0%

E(D1)

$3.60

$40

= 9.0% + 5.0% = 14.0%.

Debt Cost Plus Risk Premium Method

The difference between the cost of equity and the pretax cost of debt for a given business reflects the risk premium for bearing ownership risk versus creditor risk.

In recent years, this premium has been estimated at 3 to 5 percentage points for large, publicly traded businesses.

Current estimate can be based on the premium for an average (A-rated, b = 1.0) firm.

Debt Cost Plus RP Method (cont.)

Assume that the current risk premium is estimated to be 4 percentage points.

Then, the debt cost plus risk premium estimate for Valley Clinic’s cost of equity is 14.0 percent:

R(Re) = R(Rd) + Risk premium

= 10.0% + 4.0% = 14.0%.

Cost of Equity Final Estimate

When estimates for the cost of equity differ, judgment must be applied.

For Valley Clinic:

CAPM R(Re) = 14.0%

DCF R(Re) = 14.0%

Debt cost plus risk premium R(Re) = 14.0%

Therefore, we feel confident of a final estimate is 14.0%.

What happens if the estimates are far apart?

Assume target weights of 35 percent debt and 65 percent equity. What is Valley Clinic’s corporate cost of capital (CCC)?

CCC = wd x R(Rd) x (1 - T) + we x R(Re)

= (0.35 x 10% x 0.7) + (0.65 x 14.0%)

= (0.35 x 7.0%) + (0.65 x 14.0%)

= 2.45% + 9.10%

= 11.55%.

Which of the following statements is most correct?

The DCF method cannot be used unless the growth rate, g, is expected to be constant forever.

The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.

The DCF method is generally preferred by financial executives because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.

The risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.

Both the DCF and CAPM methods are “objective,” as opposed to “subjective,” and hence little or no judgment is required.

Self-Check

What if the business is for-profit but does not have publicly traded stock?

The biggest problem is the cost of equity estimate.

R(Re) can be estimated by:

Examining the cost of equity for similar publicly traded business.

The debt-cost-plus-risk-premium method (note that smaller businesses typically have larger risk premiums than larger businesses).

CCC = wd x R(Rd) x (1 - T) + we x R(Re) .

What if the business is not-for-profit?

Again, the biggest problem is the cost of equity estimate.

Unfortunately, there are several possible approaches to estimating the cost of equity (fund) capital to not-for-profit businesses.

CCC = wd x R(Rd) x (1 - T) + we x R(Re) .

The Cost of Fund Capital

Here are some hypotheses regarding the cost of fund capital:

It has zero cost.

It has a cost equal to the return forgone on marketable securities.

It has a cost equal to the expected growth rate of the business.

It has a cost equal to that required to maintain creditworthiness.

It has a cost equal to the cost of equity to similar for-profit businesses.

The Cost of Fund Capital (cont.)

No clear answer, but economic theory suggests the cost of equity to similar for-profit businesses.

However, not-for-profits have a nonfinancial mission, so the cost of equity might be related more to growth or creditworthiness.

Also, contributions for a specific purpose have a zero cost because there are no other investment opportunities.

The Cost of Fund Capital (cont.)

Truly similar for-profit businesses do not exist because of tax and debt proportion differentials. Hamada’s equation can be used to adjust for these differences.

Bottom line: Cost of equity estimation for not-for-profits is difficult. Some analysts use the cost of equity of “roughly similar” for-profit businesses, while others use growth rate or creditworthiness as a guide.

Using the Corporate Cost of Capital

The CCC is the overall cost of financing to the business based on the required rates of return of capital suppliers.

It establishes the benchmark rate of return that a business should require on new capital investments in the same line of business as the overall entity.

The rate is used in capital investment analyses regardless of how the new project actually will be financed.

The corporate cost of capital will be used as the “hurdle rate” for evaluating capital projects. Would the same rate be applied to all projects?

No. The corporate cost of capital reflects the risk of a business’s average project. It can be used only for projects with average risk.

The corporate cost of capital must be adjusted when the project being evaluated has greater or lesser risk.

Risk and the Cost of Capital

Low

Project Cost of

Capital (%)

CCC= 11.55

Project Risk

High

Average

Flotation (Issuance) Costs

Issuance costs on equity sales are larger than on debt sales.

Two methods are used to adjust the cost of equity for issuance costs:

Adjust project cost

Adjust cost of equity, which produces two costs: one for retained earnings and one for new stock sales

We will ignore equity issuance costs.

Divisional Costs of Capital

Often, large organizations have subsidiaries that operate in different business lines.

In this situation, it is best to estimate divisional costs of capital that reflect the unique risk (and possibly unique capital structure) of each division.

Divisional Costs of Capital (cont.)

It is important to recognize that the divisional cost of capital reflects the average risk of the division.

Thus, it must be adjusted when the project being evaluated has greater or lesser risk than the divisional average.

Cost of Capital for Small Businesses

Cost of debt is often interest rate charged by commercial bank.

Cost of equity estimated for large businesses does not recognize that the equity in small businesses typically is:

Riskier than large businesses

Less liquid (more difficult to sell)

Cost of equity often is estimated using the build-up method.

Use the CAPM (or similar model) to set the cost of equity base rate.

Add a size premium (often about 4 percentage points).

Add a liquidity premium (often about 2 percentage points).

Add an additional premium if necessary to account for risk unique to the business (i.e., technology risk).

Build-Up Method

What factors influence a business’s cost of capital?

External factors:

Level of interest rates

Tax rates

Internal factors:

Ownership (FP versus NFP)

Capital structure policy

Capital investment policy

What is the effect of an increase in interest rates? Tax rates?

Which of the following statements is most correct?

The CCC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.

There is an “opportunity cost” associated with using retained earnings; hence they are not “free.”

The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.

The CCC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.

The CCC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

Self-Check

The cost of capital to be used in capital budgeting decisions in FP businesses is the weighted average of the various types of permanent capital the firm uses, typically debt and common equity. The issue is more complex in NFP businesses.

The component cost of debt is the after-tax cost of new debt, and the cost of equity can be estimated by the CAPM, DCF, or debt cost plus risk premium approaches.

Several factors influence the cost of capital estimate for any business, including the current level of interest rates, tax rates, capital structure policy, and capital investment policy.

Three Key Learning Points

Law Week 9 Assignment- Healthcare Finance

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