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UNDERSTANDING
HEALTHCARE FINANCIAL
MANAGEMENT
LOUIS C. GAPENSKI GEORGE H. PINK
Seventh Edition
UNDERSTANDING
HEALTHCARE FINANCIAL
MANAGEMENT
AUPHA/HAP Editorial Board for Graduate Studies
Thomas J. Stranova Jr., ScD, Chairman Tulane University
LTC Lee W. Bewley, PhD, FACHE Army Baylor University
Jose A. Capriles, MD University of Puerto Rico
Dolores G. Clement, DrPH, FACHE Virginia Commonwealth University
Michael Counte, PhD St. Louis University
Jonathan P. DeShazo, PhD Virginia Commonwealth University
Mark L. Diana, PhD Tulane University
Blair D. Gifford, PhD University of Colorado
James W. Henderson, PhD Baylor University
Suzanne Hobbs, DrPH University of North Carolina at Chapel Hill
Pamela R. McCoy Loyola University Chicago
Nir Menachemi, PhD University of Alabama at Birmingham
Mary S. O’Shaughnessey, DHA University of Detroit Mercy
UNDERSTANDING
HEALTHCARE FINANCIAL
MANAGEMENT LOUIS C.
GAPENSKI GEORGE H. PINK
Seventh Edition
AUPHA
Health Administration Press, Chicago, Illinois
Association of University Programs in Health Administration, Arlington, Virginia
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Copyright © 2015 by the Foundation of the American College of Healthcare Executives. Printed in the United States of America. All rights reserved. This book or parts thereof may not be reproduced in any form without written permission of the publisher.
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Library of Congress Cataloging-in-Publication Data
Gapenski, Louis C., author. Understanding healthcare financial management / Louis C. Gapenski and George H. Pink. --
Seventh edition. p. ; cm.
Includes bibliographical references and index, ISBN 978-1-56793-706-0 (alk. paper) I. Pink, George H., author. II. American College of Healthcare Executives, issuing body. III.
Association of University Programs in Health Administration, issuing body. IV. Title. [DNLM: 1. Financial Management -United States. 2. Health Facilities--economics--United States. 3. Economics, Medical-United States. 4. Financial Management, Hospital-United States. 5. Health Facility Administration--United States. 6. Health Services-economics-United States. WX 157]
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BRIEF CONTENTS
Preface .....................................................................................................................xxi
Part I The Healthcare Environment
Chapter l. Introduction to Healthcare Financial Management ........................3
Chapter 2. Health Insurance ...........................................................................49
Chapter 3. Payments to Providers...................................................................83
Part II Basic Financial Management Concepts
Chapter 4. Time Value Analysis...................................................................127
Chapter 5. Financial Risk andRequired Return ............................................169
Part III Capital Acquisition
Chapter 6. Debt Financing............................................................................215
Chapter 7. Equity Financing .........................................................................279
Chapter 8. Lease Financing ..........................................................................333
Part IV Cost of Capital and Capital Structure
Chapter 9. Cost of Capital ............................................................................369
Chapter 10. Capital Structure.......................................................................417
Part V Capital Allocation
Chapter 11. Capital Budgeting.....................................................................469
Chapter 12. Project Risk Analysis...............................................................519
v
VI Brief Contents
Part VI Financial Condition Analysis and Forecasting
Chapter 13. Financial Condition Analysis.........................................................565
Chapter 14. Financial Forecasting .....................................................................613
Part VII Other Topics
Chapter 15. Revenue Cycle and Current Accounts Management ....................651
Chapter 16. Business Combinations and Valuation ..........................................699
Glossary ...................................................................................................................745 Appendix: Key Formulas in Chapters .....................................................................771 Index.........................................................................................................................785 About the Authors ....................................................................................................817
DETAILED CONTENTS
Preface .....................................................................................................................xx’
Part I The Healthcare Environment
Chapter 1. Introduction to Healthcare Financial Management.......................3 Learning Objectives.............. ..........................................................3 Introduction .....................................................................................3 How to Use This Book....................................................................4 The Role of Financial Management in the
Health Services Industry ............................................................6 Current Challenges..........................................................................8 Organizational Goals.......................................................................9 Tax Laws.......................................................................................13 Depreciation ..................................................................................21 Health Reform and Financial Management ..................................25 Chapter Key Concepts...................................................................29 Chapter Models, Problems, and Mini-Cases.................................30 Selected Bibliography ...................................................................31 Selected Websites..........................................................................32 Notes .............................................................................................32
Supplement. Forms of Business Organization, Ownership, and Structure.........................................................33
Supplement Learning Objectives ..................................................33 Forms of Business Organization ...................................................33 Alternative Forms of Ownership...................................................38 Organizational Structures..............................................................42 Supplement Key Concepts ............................................................46 Supplement Bibliography..............................................................47 Supplement Websites ....................................................................47 Supplement Notes .........................................................................47
vii
VIII Detailed Contents
Chapter 2. Health Insurance .............................................................................49 Learning Objectives ......................................................................49 Introduction...................................................................................49 Insurance Concepts .......................................................................50 Major Health Insurers (Third-Party Payers) .................................57 Private Insurers .............................................................................57 Public Insurers...............................................................................61 Development of Premium Rates ...................................................63 Consumer-Directed Health Plans..................................................71 Value-Based Benefit and Insurance Design..................................75 Health Reform and Health Insurance............................................76 Chapter Key Concepts ..................................................................79 Selected Case ................................................................................81 Selected Bibliography ...................................................................81 Selected Websites .........................................................................81 Notes .............................................................................................82
Chapter 3. Payments to Providers ...................................................................83 Learning Objectives ......................................................................83 Introduction...................................................................................83 Coding: The Foundation of Fee-for-Service
Reimbursement.........................................................................83 Generic Reimbursement Methods.................................................85 Financial Incentives to Providers..................................................89 Financial Risks to Providers .........................................................93 Reimbursement Methods Used by Medicare ................................95 Pay for Performance....................................................................100 Health Reform and Payments to Providers .................................109 Chapter Key Concepts ................................................................112 Chapter Models, Problems, and Mini-Cases...............................114 Selected Case ..............................................................................114 Selected Bibliography .................................................................115 Selected Websites .......................................................................116 Note.............................................................................................116
Supplement. Risk Sharing Under Capitation ..............................117 Supplement Learning Objectives ................................................117 The Need for Risk Sharing..........................................................117 Primary Care Withhold: Single Risk Pool ..................................118 Primary Care and Referral Withholds:
Two Risk Pools ......................................................................120
Detailed Contents IX
Supplement Key Concept ...........................................................124 Supplement Case.........................................................................124
Part IIBasic Financial Management Concepts
Chapter 4. Time Value Analysis....................................................................127 Learning Objectives ....................................................................127 Introduction.................................................................................127 Time Lines ..................................................................................128 Future Value of a Lump Sum (Compounding) ...........................129 Present Value of a Lump Sum (Discounting) .............................135 Opportunity Costs .......................................................................139 Solving for Interest Rate and Time.............................................141 Annuities .....................................................................................143 Perpetuities..................................................................................148 Uneven Cash Flow Streams ........................................................150 Using Time Value Analysis to Measure RO I ............................152 Semiannual and Other Compounding Periods ............................155 Amortized Loans.........................................................................159 A Review of Interest Rate Types ................................................160 Chapter Key Concepts ................................................................162 Chapter Models, Problems, and Mini-Cases...............................163 Selected Case ..............................................................................164 Selected Resources......................................................................164 Selected Website .........................................................................164 Notes ...........................................................................................164
Integrative Application ...............................................................166 The Problem................................................................................166 The Analysis ...............................................................................166 The Decision ...............................................................................168
Chapter 5. Financial Risk and Required Return .............................................169 Learning Objectives ....................................................................169 Introduction.................................................................................169 The Many Faces of Financial Risk .............................................170 Introduction to Financial Risk ....................................................171 Risk Aversion..............................................................................173 Probability Distributions .............................................................173 Expected and Realized Rates of Return......................................175 Stand-Alone Risk ........................................................................177
X Detailed Contents
Portfolio Risk and Return ...........................................................180 Portfolio Risk of Business Investments ......................................190 Portfolio Risk of Stocks (Entire Businesses) ..........................196 Portfolio Betas.............................................................................197 Relevance of the Risk Measures .................................................198 Interpretation of the Risk Measures...........................................200 The Relationship Between Risk and Return..............................201 Some Thoughts About Beta and the CAPM..............................204 Chapter Key Concepts ................................................................205 Chapter Models, Problems, and Mini-Cases...............................207 Selected Case ..............................................................................207 Selected Bibliography .................................................................207 Selected Websites .......................................................................208 Notes ...........................................................................................208
Integrative Application ...............................................................210 The Problem................................................................................210 The Analysis ...............................................................................210 The Decision ...............................................................................211
Part III Capital Acquisition
Chapter 6. Debt Financing ..............................................................................215 Learning Objectives ....................................................................215 Introduction.................................................................................215 The Cost of Money .....................................................................216 Long-Term Debt .........................................................................217 Term Loans .................................................................................217 Bonds ..........................................................................................219 Short-Term Debt .........................................................................223 Credit Ratings .............................................................................224 Interest Rate Components ...........................................................227 Term Structure of Interest Rates .................................................232 Advantages and Disadvantages of Debt Financing.....................234 Securities Valuation ....................................................................235 The General Valuation Model.....................................................236 Debt Valuation ............................................................................238 Chapter Key Concepts ................................................................251 Chapter Models, Problems, and Mini-Cases...............................253 Selected Cases.............................................................................253
■
Selected Bibliography .................................................................254 Selected Websites .......................................................................254 Notes ...........................................................................................255
Integrative Application ...............................................................256 The Problem................................................................................256 The Analysis ...............................................................................256 The Decision ...............................................................................258
Supplement. Interest Rate Levels, Types of Short- Term Debt, Debt Contracts, Bond Insurance, Debt Refunding, and Economic Factors That Influence Interest Rate Levels ...............................................................259
Supplement Learning Objectives ................................................259 Interest Rate Levels.....................................................................259 Types of Short-Term Debt ..........................................................261 Debt Contracts.............................................................................266 Bond Insurance ...........................................................................268 Debt Refunding ...........................................................................269 Economic Factors That Influence Interest
Rate Levels ............................................................................275 Supplement Key Concepts ..........................................................276
Chapter/. Equity Financing .............................................................................279 Learning Objectives ....................................................................279 Introduction.................................................................................279 Rights and Privileges of Common Stockholders ........................280 Selling New Common Stock.......................................................283 The Market for Common Stock ..................................................286 The Decision to Go Public ..........................................................288 Advantages and Disadvantages of Common
Stock Financing .....................................................................291 Equity in Not-for-Profit Corporations.........................................292 Common Stock Valuation...........................................................294 Security Market Equilibrium ......................................................306 Informational Efficiency .............................................................307 The Risk/Return Trade-Off .........................................................311 Chapter Key Concepts ................................................................312 Chapter Models, Problems, and Mini-Cases...............................313 Selected Case ..............................................................................313
xii Detailed Contents
Selected Bibliography.................................................................313 Selected Websites .......................................................................314 Notes ...........................................................................................314
Integrative Application ...............................................................316 The Problem................................................................................316 The Analysis ...............................................................................316 The Decision ...............................................................................317
Supplement. Classified Stock, Preferred Stock, Securities Regulation, and the Investment Banking Process................318
Supplement Learning Objectives ................................................318 Classified Stock ..........................................................................318 Preferred Stock............................................................................319 Securities Regulation ..................................................................323 The Investment Banking Process................................................325 Supplement Key Concepts ..........................................................330 Supplement Websites..................................................................331
Chapter 8. Lease Financing............................................................................333 Learning Objective......................................................................333 Introduction.................................................................................333 Lease Parties and Types..............................................................333 Per Procedure Versus Fixed Payment Leases .............................335 Tax Effects ..................................................................................336 Balance Sheet Effects..................................................................339 Evaluation by the Lessee.............................................................342 Evaluation by the Lessor.............................................................351 Lease Analysis Symmetry...........................................................353 Setting the Lease Payment ..........................................................354 Leveraged Leases........................................................................354 Motivations for Leasing ..............................................................356 Chapter Key Concepts ................................................................361 Chapter Models, Problems, and Mini-Cases...............................362 Selected Case ..............................................................................362 Selected Bibliography.................................................................362 Selected Websites .......................................................................363 Notes ...........................................................................................363
Integrative Application ...............................................................364 The Problem...............................................................................364
Detailed Contents xiii
The Analysis ...............................................................................364 The Decision ...............................................................................365
Part IV Cost of Capital and Capital Structure
Chapter^ Cost of Capital ...............................................................................369 Learning Objectives ....................................................................369 Introduction.................................................................................369 Overview of the Cost-of-Capital Estimation Process................369 Estimating the Cost of Debt ........................................................371 Estimating the Cost of Equity to Large Investor-
Owned Businesses.................................................................374 Estimating the Cost of Equity to Not-for-Profit
Businesses .............................................................................389 Estimating the Corporate Cost of Capital ...................................392 An Economic Interpretation of the Corporate Cost
of Capital...............................................................................394 Flotation Costs ............................................................................397 Divisional Costs of Capital .........................................................398 Warning! Warning! Warning!.....................................................399 Cost-of-Capital Estimation for Small Businesses .......................400 Factors That Influence a Business’s Cost of Capital .........403 Chapter Key Concepts ................................................................404 Chapter Models, Problems, and Mini-Cases...............................406 Selected Case ..............................................................................406 Selected Bibliography .................................................................407 Selected Websites .......................................................................407 Notes ...........................................................................................408
Integrative Application ...............................................................410 The Problem................................................................................410 The Analysis ...............................................................................410 The Decision ...............................................................................411
Supplement. Measuring the Cost of Fund Capital .............412 Supplement Learning Objectives ................................................412 Measuring the Cost of Fund Capital ...........................................412 Supplement Key Concepts ..........................................................415
Chapter io. Capital Structure ............................................................................417
Learning Objectives ....................................................................417
XIV Detailed Contents
Introduction.................................................................................417 Impact of Debt Financing on Risk and Return ...........................418 Business and Financial Risk .......................................................422 Capital Structure Theory.............................................................426 The Miller Model........................................................................433 Criticisms of the MM and Miller Models ...................................436 Financial Distress Costs..............................................................437 Trade-Off Models .......................................................................438 Asymmetric Information Model of Capital Structure .........441 Summary of the Capital Structure Models.........................443 Application of Capital Structure Theory to
Not-for-Profit Firms ..............................................................446 Making the Capital Structure Decision.......................................448 Capital Structure Decisions for Small Investor-
Owned Businesses.................................................................451 Chapter Key Concepts ................................................................453 Chapter Models, Problems, and Mini-Cases ..............................454 Selected Case ..............................................................................454 Selected Bibliography.................................................................455 Selected Websites .......................................................................455 Notes ...........................................................................................455
Integrative Application ...............................................................458 The Problem................................................................................458 The Analysis ...............................................................................459 The Decision ...............................................................................460
Supplement. The Debt Maturity Decision ..................................461 Supplement Learning Objectives................................................461 The Concept of Temporary and Permanent Assets ...................461 Alternative Debt Maturity Policies .............................................462 Conclusions Regarding Debt Maturities.....................................464 Supplement Key Concepts..........................................................465
Part V Capital Allocation
Chapter n. Capital Budgeting ...........................................................................469 Learning Objectives ....................................................................469 Introduction.................................................................................469 Project Classifications.................................................................470
r
Detailed Contents xv
The Role of Financial Analysis in Health Services Capital Budgeting ................................................................472
Overview of Capital Budgeting Financial Analysis..................472 Cash Flow Estimation.................................................................473 Cash Flow Estimation Example..................................................482 Breakeven Analysis ....................................................................489 Return on Investment Analysis...................................................492 Some Final Thoughts on Breakeven and Profitability
Analysis ...............................................................................498 Evaluating Projects with Unequal Lives ...................................499 Economic Life Versus Physical Life
(Abandonment Value) ...........................................................503 Capital Budgeting in Not-for-Profit Businesses .........................505 The Post-Audit ............................................................................508 Using Capital Budgeting Techniques in
Other Contexts.......................................................................510 Chapter Key Concepts ................................................................511 Chapter Models, Problems, and Mini-Cases ..............................513 Selected Case ..............................................................................513 Selected Bibliography.................................................................514 Selected Website.........................................................................514 Notes ...........................................................................................515
Integrative Application ...............................................................516 The Problem................................................................................516 The Analysis ...............................................................................516 The Decision ...............................................................................517
Chapter 12. Project Risk Analysis ...................................................................519 Learning Objectives ....................................................................519 Introduction.................................................................................519 Types of Project Risk..................................................................520 Relationships Among Stand-Alone, Corporate, and
Market Risks .........................................................................522 Risk Analysis Illustration............................................................523 Sensitivity Analysis ....................................................................525 Scenario Analysis .......................................................................528 Monte Carlo Simulation..............................................................531 Qualitative Risk Assessment ......................................................534 Incorporating Risk into the Decision Process.............................536
Detailed Contents
XVI
Final Risk Assessment and Incorporation for the MRI Project ..........................................................................539
Incorporating Debt Capacity into the Decision Process...................................................................541
Adjusting Cash Outflows for Risk..............................................542 Real (Managerial) Options .........................................................544 The Real Option of Abandonment..............................................548 An Overview of the Capital Budgeting
Decision Process...................................................................551 Capital Rationing ........................................................................553 Chapter Key Concepts ................................................................555 Chapter Models, Problems, and Mini-Cases ..............................557 Selected Cases ............................................................................557 Selected Bibliography.................................................................558 Selected Websites .......................................................................558 Notes ...........................................................................................558
Integrative Application ...............................................................560 The Problem................................................................................560 The Analysis ...............................................................................560 The Decision...............................................................................562
Part VI Financial Condition Analysis and Forecasting
Chapter 13. Financial Condition Analysis.......................................................565 Learning Objectives....................................................................565 Introduction.................................................................................565 Financial Reporting in the Health Sendees Industry............566 Financial Statement Analysis .....................................................572 Ratio Analysis.............................................................................573 Tying the Ratios Together: Du Pont Analysis ............................586 Operating Indicator Analysis ......................................................588 Limitations of Financial Statement and
Operating Indicator Analyses.................................................593 Economic Value Added..............................................................595 Benchmarking.............................................................................597
Key Performance Indicators and Dashboards..............................598 Chapter Key Concepts .................................................................599 Chapter Models, Problems, and Mini-Cases................................601 Selected Cases............................................................................601 Selected Bibliography................................................................601
Detailed Contents xvii
Selected Websites........................................................................602 Notes............................................................................................603
Integrative Application................................................................604 The Problem ................................................................................604 The Analysis................................................................................604 The Decision................................................................................605
Supplement. Market Value Ratios, Common Size Analysis, and Percentage Change Analysis...........................................606
Supplement Learning Objectives ................................................606 Market Value Ratios....................................................................606 Common Size Analysis ...............................................................607 Percentage Change Analysis .......................................................609 Supplement Key Concepts ..........................................................611
Chapter 14. Financial Forecasting ...................................................................613 Learning Objectives ....................................................................613 Introduction .................................................................................613 Strategic Planning........................................................................613 Operational Planning...................................................................616 Financial Planning.......................................................................617 Revenue Forecasts .......................................................................619 Creating Forecasted Financial Statements ..................................623 Constant Growth Forecasting......................................................623 Factors That Influence the External Financing
Requirement...........................................................................630 Problems with the Constant Growth Method ..............................633 Real-World Forecasting ..............................................................634 Computerized Financial Forecasting Models..............................638 Financial Controls .......................................................................640 Chapter Key Concepts.................................................................641 Chapter Models, Problems, and Mini-Cases ...............................642 Selected Cases .............................................................................643 Selected Bibliography .................................................................643 Selected Websites........................................................................644 Notes............................................................................................644
Integrative Application................................................................645 The Problem ................................................................................645 The Analysis................................................................................646 The Decision................................................................................648
Detailed Contents
XVIII
Part VII Other Topics
Chapter 15. Revenue Cycle and Current Accounts Management ...............651 Learning Objectives....................................................................651 Introduction ................................................................................651 Cash Management ......................................................................652 Marketable Securities Management ...........................................661 Revenue Cycle Management ......................................................662 Supply Chain Management ........................................................671 Current Liability Management ...................................................673 Chapter Key Concepts ................................................................677 Chapter Models, Problems, and Mini-Cases ..............................678 Selected Cases ............................................................................679 Selected Bibliography ................................................................679 Selected Websites .......................................................................681 Notes...........................................................................................681
Integrative Application ...............................................................683 The Problem ...............................................................................683 The Analysis ...............................................................................683 The Decision...............................................................................684
Supplement. Long-Term Securities Management, Credit Policy, and the EOQ Model........................................686
Supplement Learning Objectives ...............................................686 Long-Term Securities Management ...........................................686 Credit Policy ...............................................................................687 The Economic Ordering Quantity Model...................................691 Supplement Key Concepts .........................................................697
Chapter 16. Business Combinations and Valuation ......................................699 Learning Objectives....................................................................699 Introduction ................................................................................699 Level of Merger Activity............................................................700 Motives for Mergers: The Good, the Bad,
and the Ugly...........................................................................702 Types of Mergers .........................................................................706 Hostile Versus Friendly Takeovers .............................................707 Mergers Involving Not-for-Profit Businesses .............................708 Business Valuation ......................................................................710 Unique Problems in Valuing Small Businesses...........................718
Detailed Contents XIX
Setting the Bid Price ...................................................................719 Structuring the Takeover Bid .....................................................722 Due Diligence Analysis ..............................................................723 Corporate Alliances ....................................................................724 Goodwill .....................................................................................726 Chapter Key Concepts ................................................................727 Chapter Models, Problems, and Mini-Cases ..............................728 Selected Cases ............................................................................729 Selected Bibliography.................................................................729 Selected Websites .......................................................................730 Notes...........................................................................................730
Integrative Application ...............................................................731 The Problem ...............................................................................731 The Analysis ...............................................................................732 The Decision...............................................................................733
Supplement. Merger Regulation, the Role of Investment Bankers, and Who Wins? The Empirical Evidence ............734
Supplement Learning Objectives................................................734 Merger Regulation......................................................................734 The Role of Investment Bankers ................................................739 Who Wins? The Empirical Evidence .........................................741 Supplement Key Concepts..........................................................743
Glossary...................................................................................................................745 Appendix: Key Formulas in Chapters .....................................................................771 Index ........................................................................................................................785 About the Authors....................................................................................................817
PREFACE
It has been 22 years since Understanding Healthcare Financial Manage- ment was first published, and it is now in its seventh edition. The original concepts of the book included (1) a broad definition of the health services industry that recognized that many of today’s health services management students are seeking careers outside the hospital industry and (2) a focus on the environmental factors that are unique to health services and hence make healthcare financial management different from generic corporate financial management. Although the book remains grounded in these original con- cepts, we have made many updates and improvements along the way and have tried very hard to ensure that the book continues to be of maximum value to both students and instructors. In today’s healthcare environment, financial issues are of paramount importance, and future managers must be prepared to deal with these issues as they strive to improve the delivery of health ser- vices to all Americans. «
Concept of the Textbook
Our goal in creating this edition, like all previous editions, is to produce a textbook that provides health services management students with (1) an operational knowledge of healthcare financial management theory and con- cepts and, even more important, (2) the ability to apply this knowledge to real-world decision making. Additionally, we want the textbook to be useful as a reference during internships and residencies as well as after graduation. Finally, we want a textbook that students find user friendly, meaning one that they enjoy reading and could learn from on their own. If students don’t find a textbook interesting, understandable, and useful, they won’t read it!
The book begins with basic concepts pertaining to the health services industry and financial management. It then progresses to illustrate how managers of healthcare businesses can apply financial management theory and concepts to make better decisions—that is, decisions that promote the financial well-being of the organization.
Preface
XXII
Intended Market and Use
The book is designed primarily for use in graduate-level courses for students whose primary interest is the management of health services organizations. The book can be used for other student clienteles, but the absence of explicit accounting content, the amount of theory, and the nature of the ancillaries make the book most suitable for MHA, MBA (healthcare concentration), and MPH (management concentration) students. Also, because Understand- ing Healthcare Financial Management is designed to provide students with a higher level of cognition according to Bloom’s Taxonomy, the end-of- chapter problems are provided on spreadsheets rather than printed in the textbook. Finally, student knowledge, skills, and abilities are maximized when the textbook is paired with cases.
Alternative Course Formats
There is no best approach to teaching a healthcare financial management course. The approach varies with students’ backgrounds, instructors’ inter- ests, class contact hours, and the role of the course in the overall curriculum. Because these factors change, most instructors vary their approaches over time. Still, it may be useful to adopters to learn how the textbook has been used in multicourse formats at the University of Florida (UF) and the Uni- versity of North Carolina at Chapel Hill (UNC-CH):
In the first year of the UF MHA program, students take an introduc- tory course that covers both healthcare accounting and financial manage- ment. The text used for this course is Healthcare Finance: An Introduction to Accounting and Financial Management. The pure healthcare financial management course is taken in the second year of the program. Most of the textbook is covered, along with 12 cases (one per week, after some introduc- tory material), in one semester. In addition, a few accounting-oriented cases from the casebook are typically included as refreshers. (The casebook is dis- cussed in detail later in this preface.)
In the first year of the UNC-CH MHA program, students take three courses that cover financial accounting, management accounting, and health- care reimbursement. The healthcare financial management course is offered in the second year of the program, and the entire textbook is covered. The team-based learning approach to these courses makes extensive use of the end-of chapter models, the problems, and the cases and mini-cases featured in the casebook.
In both formats, the dominant theme is financial management because a well-grounded understanding of financial decision making is more important for most students than a better understanding of accounting.
Preface XXIII
Also our students are studying to be general managers, not financial staff specialists, so we are willing to sacrifice depth to expose students to a large range of topics.
Financial management courses are generally taught either as a theo- retically based lecture course, as a pragmatically based pure case course, or as a blend of theory and practice that combines lectures with some cases. Over time, we have used all three approaches, but the one that we have found best is a blend of theory and practice, but with a strong bias toward practice. Thus, we lecture occasionally but use a large number of cases, mini-cases, and problems to provide insights into the complex financial decisions faced by practicing healthcare managers.
Understanding Healthcare Financial Management ■provides the theory and concepts behind financial decision making in the health services industry and the nuts-and-bolts tools required to implement the theory and concepts. Students learn the theory and concepts of healthcare financial management from the textbook and periodic lectures and then implement the concepts by working cases.
Although the textbook is designed primarily for use in a second course in financial management, a great deal of introductory material has been included. Despite students having already completed one or more finance courses, we have found that many do not have a good grasp of the basic fundamentals of financial management. Thus, they appreciate that the book reviews basic concepts in addition to presenting new material. After all, rep- etition is the key to learning.
Changes in the Seventh Edition
Since the sixth edition was published, we have used the textbook several times and have received many comments from users at other universities. Furthermore, Health Administration Press has solicited and received a num- ber of thoughtful reviews. The reaction of students, other professors, and the market in general has been overwhelmingly positive; every comment indicates that the basic concept of the textbook is sound. Even so, nothing is perfect, and the health services industry is evolving at a dizzying pace. These circumstances have prompted a number of changes to the textbook.
We have two primary goals for the seventh edition: (1) to make the book even more healthcare focused and (2) to make the book even more reader friendly. In addition, we have two primary goals related to the ancil- lary material: (1) to create a multiple-choice test bank for instructor use and (2) to increase the quantity and scope of the spreadsheet problems. Many revisions were made to accomplish these and other goals; here is a list of the most important. (Please note that some of the healthcare organizations used
xxiv Preface
as examples in this and previous editions are fictitious. Any similarities in organizational name and characteristics are unintentional.)
New, Revised, and Relocated Material • Part I (The Healthcare Environment) has been expanded from two to
three chapters, incorporating most of the material from the previous edition’s Chapter 17 (Capitation, Risk Sharing, Pay for Performance, and Consumer-Directed Health Plans). Now, all information on health insurance and provider payments is at the beginning, which emphasizes the healthcare focus of the book.
• Chapter 18 (Financial Risk Management) has been removed from the book and placed online. This material, although important to the financial staff, is not of prime relevance to most student users. Note that another chapter (Chapter 17), which focuses on distributions to owners, is also available online, as in the previous edition.
• Material from the securities valuation chapter (the previous edition’s Chapter 7) has been incorporated into the debt and equity chapters (chapters 6 and 7); the change places securities valuation with the matching descriptive content. The result of these changes is a book with 16 chapters and 2 online chapters.
• Complete sections of the text considered nonessential have been moved into the new Chapter Supplement feature that can be found at the end of many chapters. Now, all chapters are roughly the same length, with material that is important (but not essential) separated from the primary content. By removing noncritical sections, students are better able to focus on essential content.
• An Appendix has been added that contains a summary of formulas by chapter and key equation number. This feature permits students to more easily review their knowledge of key equations.
Chapter Format Changes • Key equations are now numbered and highlighted in a box. This
makes it easier for students to identify and learn essential mathematical relationships.
• Sidebars are added that present bits of information that are useful and relevant but not essential to understanding the concept being discussed in the adjacent text. The purpose of this feature is to lighten the look and tone of the book; enhance the flow of essential concepts; and make readers think about the concepts presented in a nonacademic, everyday-life way.
Preface XXV
• Many chapters, when appropriate, now have an Integrative Application section at the end. This new feature presents a scenario containing a key decision methodology discussed in the chapter. Essentially, the Integrative Application is a relatively long example (with both narrative and analysis) that ties together related concepts presented separately in the chapter and illustrates how those concepts are used in managerial decision making.
Ancillary Changes • A multiple-choice test bank has been created that instructors can use
for in-class quizzes or for other purposes as needed. • All chapter spreadsheet problem sets have been expanded to include
additional problems as well as to cover more text concepts.
Miscellaneous Changes • All aspects of the text discussion as well as the references have been
updated and clarified as needed. Particular care has been taken to include content reflective of the changed healthcare financial environment after the passage of the Affordable Care Act in 2010. In addition, contemporary real-world examples have been added throughout the text.
Ancillary Materials
Several ancillary materials have been designed to enhance the learning experience.
Materials for Students Four useful ancillaries are available to students (as well as instructors) who use this text. All student ancillary materials can be accessed on this book’s companion website: ache.org/books/UHFM7. A section called Chapter Models, Problems, and Mini-Cases at the end of each chapter indicates whether text models, end-of-chapter problems, and mini-cases are available.
1. Text models. Most of the chapters have accompanying Excel® models that illustrate the text calculations and additional calculations relevant to the chapter material. The purpose of these spreadsheet models is twofold. First, students’ learning is enhanced because they can more easily visualize how various input factors influence a particular calculation. For example, the spreadsheet model for capital budgeting
Preface XXVI
On the web at: ache.org/book s/
UHFM7
allows students to change input values (such as volume and average reimbursement) and immediatc’v see the effects these changes have on profitability. Second, the spreadsheets enable students to learn the mechanics of spreadsheet analysis in a less challenging context than the mini-cases (discussed later) because these models typically are not part of a graded assignment. Note that sections of the text that have accompanying models are designated by a web icon (see margin).
2. End-of-chapter problems. A set of problems in spreadsheet format is available for most chapters. The instructor may assign the problems as homework, or students can work them on their own to gain a deeper understanding of the topics in the chapter.
3. Mini-cases. A mini-case in spreadsheet format is available for most chapters. The mini-cases are more complicated than the end-of- chapter problems. Again, the instructor may assign the mini-cases as homework, or students can work them on their own to gain a deeper understanding of the topics in the chapter.
4. Online chapters. Two chapters are available online: Chapter 17 (Distributions to Owners: Bonuses, Dividends, and Repurchases) and Chapter 18 (Financial Risk Management). These can be used by instructors in class or by students for independent learning.
Materials for Instructors In addition to the materials for students, four useful ancillaries are available to instructors who adopt this text. Instructor ancillaries are contained in a secure area and available only to adopters of this text. For access informa- tion, e-mail [email protected]. A section called Chapter Models, Problems, and Mini-Cases at the end of each chapter indicates whether end-of-chapter problems and mini-cases are available.
1. Slideshow. Sets of PowerPoint® slides that cover essential topics are available for each chapter. Each presentation contains approximately 40 slides featuring concepts, graphs, tables, lists, and calculations. Copies of the slides can be provided to students for use as lecture notes. Many instructors will find these slides useful, either without modification or customized to meet unique course and student requirements.
2. End-of-chapter problem solutions. A set of problems in spreadsheet format is available for most chapters. Solutions to these problem sets, which are available only to instructors, can be used to grade homework or can be provided to students for self-study.
3. Mini-case solutions. A mini-case in spreadsheet format is available for most chapters. Solutions to the mini-cases, which are available only to
Preface XXVII
instructors, can be used to grade homework, to help students prepare for a case, or in other ways the instructor deems appropriate.
4 Test bank. A multiple-choice test bank that consists of roughly 20 questions/problems per chapter is available to instructors. Most adopters use problems and/or cases to evaluate student knowledge, skills, and abilities; however, a test bank often is useful for in-class quizzes or for other purposes.
The Casebook In addition to the free ancillaries, many adopters pair this textbook with its accompanying casebook, Cases in Healthcare Finance. The most realistic application of healthcare finance occurs in health services organizations, and there is no substitute for on-the-job experience. The next best thing—and the only real option for the classroom—is to use cases to simulate, to the extent possible, the environment in which finance decisions are made. Cases provide students with an opportunity to bridge the gap between learning concepts in a lecture setting and applying them on the job. By working cases, students can be better prepared to deal with the multitude of problems that arise in the practice of healthcare financial management.
Cases in Healthcare Finance, 5th edition, contains 32 cases that focus on the practice of healthcare finance, including accounting, in provider organizations. In general, each case addresses a single financial issue, such as a capital investment decision. The uncertainty of the input data, along with the presence of relevant nonfinancial factors, makes each case interesting and challenging. The case settings include a variety of provider organizations, including hospitals, medical practices, integrated delivery systems, and man- aged care organizations. In addition to cases that focus purely on financial decisions, the casebook contains seven mini-cases that address ethical issues related to healthcare finance. The ethics mini-cases are not quantitative in nature but rather are designed to promote discussion about finance situations that have ethical implications.
In general, cases may be classified as directed or nondirected. Directed cases include a specific set of questions that students must answer to complete the case, while nondirected cases (as we use the term) contain only general guidance to point students in the right direction. The cases in the casebook are nondirected, because such cases closely simulate how real-world managers confront financial decision making. However, students who stray from the key issues of the cases often do not obtain full value from their effort.
We have found that students with more advanced finance skills gain the most from nondirected cases, while students who have had less finance exposure gain most from directed cases. The online instructors’ material for
XXVIII Preface
the casebook contains sets of questions that can be used to convert each of the cases to directed cases. Thus, instructors can use the cases in either way, depending on the experience of the students, the objectives of the course, and the extent to which cases will be used.
Spreadsheet analysis has become extremely important in all aspects of healthcare finance. Students must be given an opportunity to hone computer skills and be allowed, or required, to use spreadsheet programs to assist in financial analyses. Furthermore, spreadsheet models can reduce the amount of “busywork” required to perform the required calculations and hence leave students with more time to focus on financial management issues. Because of these factors, we developed well-structured, user-friendly spreadsheet models for every case to enable students to perform more efficient analyses. In addition, spreadsheet models enable students to easily create graphics and other computer outputs that will enhance the quality of the analyses and any required presentations.
The student version of each case model is complete in that no mod- eling is required to obtain a base case solution. However, zeros have been entered for all input data, so students must identify and enter the appropriate input values. The model then calculates the base case solution automatically. However, the models do not contain risk analyses or other extensions, such as graphics, so students must modify the models as necessary to make them most useful in completing the cases.
Cases in Healthcare Finance, 5th edition, is discounted 20 percent when purchased with Understanding Healthcare Financial Management, 7th edition. For more information, call Health Administration Press at (301) 362-6905 or e-mail [email protected].
Acknowledgments
This book reflects the efforts of many people. The following individuals reviewed previous editions of the textbook and provided many valuable com- ments and suggestions for improvement:
Doug Conrad of the University of Washington Tom Getzen of Temple University Mike McCue of Virginia Commonwealth University Dean Smith of the University of Michigan Jack Wheeler of the University of Michigan
Special thanks are also due to Saleema Karim and Spencer Budd who helped us revise the seventh edition.
Preface XXIX
Colleagues, students, and staff at the University of Florida and at the University of North Carolina at Chapel Hill provided inspirational as well as tangible support during the development and testing of this edition. And last, but certainly not least, we thank the staff at Health Administration Press; they were instrumental in ensuring the quality and usefulness of the textbook.
Errors in the Textbook
Despite the significant effort that has been expended on this edition, it is safe to say that some errors exist. To create the most error-free and useful textbook possible, we strongly encourage students and instructors to write or e-mail us with comments and suggestions for improvement. We welcome and value your input!
Conclusion
Good financial management is vital to the economic well-being of the health services industry. Because of its importance, financial management theory and concepts should be thoroughly understood and correctly applied—but this feat is easier said than done. We hope that Understanding Healthcare Financial Management will help you better appreciate the financial manage- ment problems faced by the health services industry today and provide guid- ance on how best to solve them.
Louis C. Gapenski, PhD Box 100195 Health Science Center University of Florida Gainesville, FL 32610-0195 gapenski@phhp. ufl. edu
George H. Pink, PhD 1105-D McGavran-Greenberg Hall Department of Health Policy and
Management University of North Carolina at
Chapel Hill Chapel Hill, NC 27599-7411 [email protected]
PART
THE HEALTHCARE ENVIRONMENT
Two factors make the provision of health services different from the pro-vision of other services. First, many providers are organized as not-for-profit corporations as opposed to investor owned. Second, payment for services typically is made by third parties rather than by patients, who receive the services. By focusing on these differences, Part I of the text provides stu- dents with unique background information that creates the framework for financial decision making in healthcare organizations.
Chapter 1 discusses the institutional setting for the delivery of health- care services. Topics covered include the role of financial management, orga- nizational goals, tax laws, and the implications of health reform for healthcare financial management. The Chapter Supplement reviews alternative forms of organization and ownership.
Chapter 2 focuses on insurance concepts and the third-party-payer system. The chapter includes a discussion of consumer-directed health plans and the implications of health reform for health insurance.
Chapter 3 describes the primary methods that public and private insurers use to pay healthcare providers for their services. Healthcare manag- ers must understand who the payers are and the payment methods they use because these external factors have a profound influence on financial decision making. The chapter includes a discussion of pay-for-performance and the implications of health reform for payments to providers.
-1
CHAPTER
INTRODUCTION TO HEALTHCARE FINANCIAL MANAGEMENT
1 Learning Objectives After studying this chapter, readers should be able to
• explain the difference between accounting and financial management;
• discuss the role of financial management in health services organizations;
• explain how the goals of investor-owned and not-for-profit businesses differ;
• describe, in general terms, the tax laws that apply both to individuals and to healthcare businesses; and
• assess the implications of health reform for the financial management of healthcare organizations.
Introduction
The study of healthcare financial management is fascinating and rewarding. It is fascinating because so many of the concepts involved have implications for both professional and personal behavior. It is rewarding because the healthcare environment today, and in the foreseeable future, is forcing managers to place increasing emphasis on financial implications when making operating decisions.
First and foremost, financial management is a decision science. Whereas accounting provides decision makers with a rational means by which to bud- get for and measure a business’s financial performance, financial management provides the theory, concepts, and tools necessary to make better decisions. Thus, the primary purpose of this textbook is to help healthcare managers and students become better decision makers. The text is designed primarily for nonfinancial managers, although financial specialists—especially those with accounting rather than finance backgrounds or those moving into the health services industry from other industries—will also find the text useful.
The major difference between this text and corporate finance texts is that this text focuses on factors unique to the health services industry. For
3
example, the provision of health services is dominated by not-for-profit or nonprofit organizations (private and governmental), which are inherently dif- ferent from investor-owned businesses.1 Also, the majority of payments made to healthcare providers for services are not made by patients—the consumers of the services—but rather by some third-party payer (e.g., a commercial insurance company or a government program). This text emphasizes ways in which the unique features of the health services industry affect financial management decisions.
Although this text contains some theory and a great number of financial management concepts, its primary emphasis is on how managers can apply the theory and concepts; thus, it does not contain the traditional end-of-chapter questions and problems. (Note, however, that end-of-chapter problems in spreadsheet format are available as ancillary materials.) Rather, the text is designed to be used with the book Cases in Healthcare Finance, 5th edition, which contains cases based on real-life decisions faced by practic- ing healthcare managers. The cases are designed to enable students to apply the skills learned in this text’s chapters in a realistic context, where judgment is just as critical to good decision making as numerical analysis. Furthermore, the cases are not directed, which means that although students receive some guidance, they must formulate their own approach to the analyses, just as real-world decision makers must do.2
This text and die casebook are oriented toward the use of spreadsheets that can help managers make better decisions. This text has accompanying spreadsheet models that illustrate the key concepts presented in many of the chapters. The casebook has spreadsheet models that make the quantitative portion of the case analyses easier to do and more complete.
It is impossible to create a text that includes everything that a manager needs to know about healthcare financial management. It would be foolish even to try because the industry is so vast and is changing so rapidly that many of the details needed to become completely knowledgeable in the field can be learned only through contemporary experience. Nevertheless, this text provides the core competencies readers need to (1) judge the validity of analyses performed by others, usually financial staff specialists or consultants, and (2) incorporate sound financial management theory and concepts in their own managerial and personal decision making.
How to Use This Book
The overriding goal in creating this text was to provide an easy-to-read, content-filled book on healthcare financial management. The text contains several features designed to assist in learning the material.
Chapter i: Introduction to Healthcare Financial Management 5
First, pay particular attention to the Learning Objectives listed at the beginning of each chapter. These objectives give readers a feel for the most important topics in each chapter and set learning goals for that chapter. After each major section, except the Introduction, one or more Self-Test Ques- tions are listed. Answers to these questions are not provided. When you finish reading each major section, try to provide reasonable answers to these ques- tions. Your responses do not have to be perfect, but if you are not satisfied with your answer, reread that section before proceeding.
Within the book, italics and boldface are used to indicate special terms. Italics are used whenever a key term is introduced; thus, italics alert readers that a new or important concept is being presented. Boldface is used solely for emphasis; thus, the meaning of a boldface word or phrase has unusual significance to the point being discussed. Boxes are used to highlight key for- mulae or equations. As indicated in the Preface, the book has accompanying spreadsheet models that match—and sometimes expand on—selected calcu- lations in the text. The sections of the text that have accompanying models are indicated by a Web icon (see the margin).
In addition to in-chapter learning aids (e.g., sidebars, time lines, solu- tions), materials designed to help readers learn healthcare financial manage- ment are included at the end of each chapter. First, many chapters contain an Integrative Application section that shows how a method covered in the chapter can be used to solve a practical problem. Second, a new feature called Chapter Supplement can be found immediately after many chapters; this includes materials that are important but not essential to the concepts discussed. Third, a summary section titled Chapter Key Concepts briefly reviews the most important topics covered in the chapter. If the meaning of a key concept is not apparent, you may want to review the applicable section. Fourth, a section called Chapter Models, Problems, and Mini-Cases indicates if spreadsheet models, problem sets, and mini-cases are available for that chap- ter. (See the Preface for more information on these ancillaries.) Finally, each chapter includes Selected Bibliography and Selected Websites. The books and articles listed in the bibliography can provide a more in-depth understanding of the material covered in the chapter, while the list of websites is designed to just scratch the surface of relevant material available online.
Taken together, the pedagogic structure of the book is designed to make the learning of healthcare financial management as easy and efficient as possible.
On the web at: ache.org/book s/ UHFM7
1. Briefly describe the key features of the text designed to enhance the learning experience.
SELF-TEST QUESTION
6 Understanding Healthcare Finance Management
The Role of Financial Management in the Health Services Industry
Until the 1960s, financial management all industries was generally viewed as descriptive in nature, its primary role being to secure the financing needed to meet a business’s operating objectives. A business’s marketing, or plan- ning, department would project demand for the firm’s goods or services; facilities managers would estimate the assets needed to meet the projected demand; and the finance department would raise the money needed to pur- chase the required land, buildings, equipment, and supplies. The study of financial management concentrated on business securities and the markets in which they are sold and on how businesses could access the financial markets to raise capital. Consequently, financial management textbooks of that era were almost totally descriptive in nature.
Today, financial management plays a much larger role in the overall management of a business. Now, the primary role of financial management is to plan for, acquire, and utilize funds (capital) to maximize the efficiency and value of the enterprise. Because of this role, financial management is known also as capital finance. The specific goals of financial management depend on the nature of the business, so we will postpone that discussion until later in the chapter. In larger organizations, financial management and accounting are separate functions, although the accounting function typically is carried out under the direction of the organization’s chief financial officer (CFO) and hence falls under the overall category of “finance.”
In general, the financial management function includes the following activities:
• Evaluation and planning. First and foremost, financial management involves evaluating the financial effectiveness of current operations and planning for the future.
• Long-term investment decisions. Although these decisions are more important to senior management, managers at all levels must be concerned with the capital investment decision process. Such decisions focus on the acquisition of new facilities and equipment (fixed assets) and are the primary means by which businesses implement strategic plans; hence, they play a key role in a business’s financial future.
• Financing decisions. All organizations must raise funds to buy the assets necessary to support operations. Such decisions involve the choice between the use of internal versus external funds, the use of debt versus equity capital, and the use of long-term versus short-term debt. Although senior managers typically make financing decisions, these choices have ramifications for managers at all levels.
Chapter i: Introduction to Healthcare Financial Management 7
• Working capital management. An organization’s current, or short-term, assets—such as cash, marketable securities, receivables, and inventories—must be properly managed to ensure operational effectiveness and reduce costs. Generally, managers at all levels are involved, to some extent, in short-term asset management, which is often called working capital management.
• Contract management. Health services organizations must negotiate, sign, and monitor contracts with managed care organizations and third-party payers. The financial staff typically has primary responsibility for these tasks, but managers at all levels are involved in these activities and must be aware of their effect on operating decisions.
• Financial risk management. Many financial transactions that take place to support the operations of a business can increase a business’s risk. Thus, an important financial management activity is to control financial risk.
In times of high profitability and abundant financial resources, the finance function tends to decline in importance. Thus, when most health- care providers were reimbursed on the basis of costs incurred, the role of finance was minimal. At that time, the most critical finance function was cost accounting because it was more important to account for costs than to control them. Today, however, healthcare providers are facing an increas- ingly hostile financial environment, and any business that ignores the finance function runs the risk of financial deterioration, which ultimately can lead to bankruptcy and closure.
In recent years, providers have been redesigning their finance func- tions to recognize the changes that have been occurring in the health services industry. Historically, the practice of finance had been driven by the Medicare program, which demanded that providers (primarily hospitals) churn out a multitude of reports to comply with regulations and maximize Medicare rev- enues. Third-party reimbursement complexities meant that a large amount of time had to be spent on cumbersome accounting, billing, and collection procedures. Thus, instead of focusing on value-adding activities, most finance work focused on bureaucratic functions. Today, to be of maximum value to the enterprise, the finance function must support cost-containment efforts, managed care and other payer contract negotiations, joint venture decisions, and participation in accountable care organizations and integrated delivery systems. Finance must help lead organizations into the future rather than merely record what has happened in the past.
In this text, the emphasis is on financial management, but there are no unimportant functions in health services organizations. Managers must understand a multitude of functions, such as marketing, accounting, and
8 Understanding Healthcare Finance Management
human resource management, in addition to financial management. Still, all business decisions have financial implications, so all managers—whether in operations, marketing, personnel, or facilities—must know enough about financial management to incorporate financial implications in decisions about their own specialized areas. An understanding of the theory and principles of financial management will make them even more effective at their own spe- cialized work.
SELF-TEST QUESTIONS 1. What is the role of financial management in today’s health services
organizations? 2. How has this role changed over time?
Current Challenges
In January 2014, the American College of Healthcare Executives (ACHE) announced the top issues confronting hospitals.3 Responses to a 2013 survey of 388 community hospital CEOs were used to determine these issues. The top five concerns identified by respondents are as follows:
1. Financial challenges 2. Health reform implementation 3. Government mandates 4. Patient safety and quality 5. Care for the uninsured
The specific financial challenges facing hospitals, as reported by the CEOs, are as follows:
• Government funding cuts • Medicaid and Medicare reimbursement • Bad debt • Decreasing inpatient volume • Increasing costs for staff, supplies, and so on • Competition from other providers • Inadequate funding for capital improvements • Revenue cycle management (converting charges to cash) • Other commercial insurance reimbursement • Managed care payments • Emergency departments
Chapter 1: Introduction to Healthcare Financial Management 9
Financial challenges were at the top of the list of hospital CEOs’ con- cerns in 2013, just as they had been for the past ten years. As such, financial issues are of primary importance to today’s healthcare managers. The remain- der of this book is dedicated to helping you confront and solve these issues.
1 What are some important issues confronting hospitals today? SELF-TEST QUESTION
Organizational Goals
This text focuses on business finance. Because most healthcare managers work for corporations and because not-for-profit businesses are organized as corporations, this text emphasizes this form of organization. The other forms of business organization and alternative forms of ownership are described in the Chapter Supplement (see the end of this chapter).
Financial decisions are not made in a vacuum but with an objective in mind. An organization’s financial management goals must be consistent with and support the overall goals of the business. Thus, by discussing organiza- tional goals, health services organizations develop a framework for financial decision making.
In a proprietorship, partnership, or small, privately owned corpora- tion, the owners of the business generally are also its managers. In theory, the business can be operated for the exclusive benefit of the owners. If the owners want to work hard to maximize wealth, they can. On the other hand, if every Wednesday is devoted to golf, no one is hurt. (Of course, the busi- ness still has to cater to its customers or else it will not survive.) It is in large publicly owned corporations, in which owners and managers are separate parties, that organizational goals become most important.
Large, Investor-Owned Corporations From a financial management perspective, the primary goal of investor- owned corporations is generally assumed to be shareholder wealth maximiza- tion, which translates to stock price maximization. Investor-owned corpora- tions do, of course, have other goals. Managers, who make the decisions, are interested in their own personal welfare, in their employees’ welfare, and in the good of the community and society at large. Still, the goal of stock price maximization is a reasonable operating objective on which to build financial decision rules.
The primary obstacle to shareholder wealth maximization as the goal of investor-owned corporations is the agency problem. An agency problem exists when one or more individuals (the principals) hire another individual or group of individuals (the agents) to perform a service on their behalf and
10 Understanding Healthcare Finance Management
then delegate a decision-making authority to those agents. In a healthcare financial management framework, the agency problem exists between stock- holders and managers and between debtholders and stockholders.
The agency problem between stockholders and managers occurs because the managers of large, investor-owned corporations hold only a small proportion of the firm’s stock, so they benefit little from stock price increases. On the other hand, managers often benefit substantially from actions detrimental to stockholders’ wealth, such as increasing the size of the firm to justify higher salaries and more fringe benefits; awarding themselves generous retirement plans; and spending too much on such items as office space, personal staff, and travel. Clearly, many situations can arise in which managers are motivated to take actions that are in their best interests, rather than in the best interests of stockholders.
However, stockholders recognize the agency problem and counter it by creating the following mechanisms to keep managers focused on share- holder wealth maximization:
• The creation of managerial incentives. More and more firms are creating incentive, compensation plans that tie managers’ compensation to the firm’s performance. One tool often used is stock options, which allow managers to purchase stock at some time in the future at a given price. Because the options are valuable only if the stock price climbs above the exercise price (the price that the managers must pay to buy the stock), managers are motivated to take actions to increase the stock price. However, because a firm’s stock price is a function of both managers’ actions and the general state of the economy, a firm’s managers could be doing a superlative job for shareholders but the options could still be worthless. To overcome the inherent shortcoming of stock options, many firms use performance shares as the managerial incentive. Performance shares are given to managers on the basis of the firm’s performance as indicated by objective measures, such as earnings per share, return on equity, and so on. Not only do managers receive more shares when targets are met; the value of the shares is also enhanced if the firm’s stock price rises. Finally, many businesses use the concept of economic value added (EVA) to structure managerial compensation. (EVA is discussed in Chapter 13.) All incentive compensation plans—stock options, performance shares, profit-based bonuses, and so forth—are designed with two purposes in mind. First, they offer managers incentives to act on factors under their control in a way that will contribute to stock price maximization. Second, such plans help firms attract and retain top-quality managers.4
• The threat of firing. Until the 1980s, the probability of a large firm’s stockholders ousting its management was so remote that it
Chapter 1: Introduction to Healthcare Financial Management 11
posed little threat. Ownership of most firms was so widely held, and management’s control over the proxy (voting) mechanism was so strong, that it was almost impossible for dissident stockholders to fire a firm’s managers. Today, however, about 70 percent of the stock of an average large corporation, such as pension funds and mutual funds, is held by institutional investors rather than individual investors. These institutional money managers have the clout, if they choose to use it, to exercise considerable influence over a firm’s managers and, if necessary, to remove the current management team by voting it off the board. • The threat of takeover. A hostile takeover—the purchase of a firm against its management’s wishes—is most likely to occur when a firm’s stock is undervalued relative to its potential because of poor management. In a hostile takeover, a potential acquirer makes a direct appeal to the shareholders of the target firm to tender, or sell, their shares at some stated price. If 51 percent of the shareholders agree to tender their shares, the acquirer gains control. When a hostile takeover occurs, the managers of the acquired firm often lose their jobs, and any managers permitted to stay generally lose the autonomy they had prior to the acquisition. Thus, managers have a strong incentive to take actions to maximize stock price. In the words of the president of a major drug manufacturer, “If you want to keep control, don’t let your company’s stock sell at a bargain price.”
In summary, managers of investor-owned firms can have motivations that are inconsistent with shareholder wealth maximization. Still, sufficient mechanisms are at work to force managers to view shareholder wealth maximization as an important, if not primary, goal. Thus, shareholder wealth maximization is a reasonable goal for investor-owned firms.
Not-for-Profit Corporations Because not-for-profit corporations do not have shareholders, shareholder wealth maximization is not an appropriate goal for such organizations. Not- for-profit firms consist of a number of classes of stakeholders who are directly affected by the organization. Stakeholders include all parties who have an interest—usually financial—in the organization. For example, a not-for-profit hospital’s stakeholders include the board of trustees, managers, employees, physicians, creditors, suppliers, patients, and even potential patients (who may include the entire community). An investor-owned hospital has the same set of stakeholders, plus one additional class—stockholders. While managers of investor-owned firms have to please only one class of stakeholders—the shareholders—managers of not-for-profit firms face a different situation. They have to please all of the organization’s stakeholders because no single, well-defined group exercises control.
12 Understanding Healthcare Finance Management
Many people argue that managers of not-for-profit firms do not have to please anyone because they tend to dominate the board of trustees, who are supposed to exercise oversight. Others argue that managers of not-for- profit firms have to please all of the firm’s stakeholders because all are neces- sary to the successful performance of the business. Of course, even managers of investor-owned firms should not attempt to enhance shareholder wealth by treating any of their firm’s other stakeholders unfairly because such actions ultimately will be detrimental to shareholders.
Typically, the goal of not-for-profit firms is stated in terms of a mis- sion. An example is the mission statement of Bayside Memorial Hospital, a 450-bed, not-for-profit, acute care hospital:
Bayside Memorial Hospital, along with its medical staff, is a recognized, innova- tive healthcare leader dedicated to meeting the needs of the community. We strive to be the best comprehensive healthcare provider through our commitment to excellence.Although this mission statement provides Bayside’s managers and
employees with a framework for developing specific goals and objectives, it does not provide much insight into the goals of the hospital’s finance func- tion. For Bayside to accomplish its mission, its managers have identified five financial goals:
1. The hospital must maintain its financial viability. 2. The hospital must generate sufficient profits to continue to provide its
current range of healthcare services to the community. Buildings and equipment must be replaced as they become obsolete.
3. The hospital must generate sufficient profits to invest in new medical technologies and services as they are developed and needed.
4. The hospital should not rely on its philanthropy program or government grants to fund its operations and growth, although it will aggressively seek such funding.
5. The hospital will strive to provide services to the community as inexpensively as possible, given the above financial requirements.
In effect, Bayside’s managers are saying that to achieve the hospital’s commitment to excellence as stated in its mission statement, the hospital must remain financially strong and profitable. Financially weak organizations cannot continue to accomplish their stated missions over the long run. What is interesting is that Bayside’s five financial goals are probably not much dif- ferent from the financial goals of Jefferson Regional Medical Center (JRMC), a for-profit competitor. Of course, JRMC has to worry about providing a
Chapter i: Introduction to Healthcare Financial Management 13
return to its shareholders, and it receives only a small amount of contribu- tions and grants. To maximize shareholder wealth, JRMC also must retain its financial viability and have the financial resources necessary to offer new services and technologies. Furthermore, competition in the market for hos- pital services will not permit JRMC to charge appreciably more for services than its not-for-profit competitors.
1. What is the difference between the goals of investor-owned and not-for-profit firms?
2. What is the agency problem, and how does it apply to investor- owned firms?
3. What factors tend to reduce the agency problem?
SELF-TEST QUESTIONS
Tax Laws
The value of any financial asset (such as a share of stock issued by Tenet Healthcare or a municipal bond issued by the Alachua County Healthcare Financing Authority on behalf of Shands Health Care) and the value of many real assets (such as an MRI [magnetic resonance imaging] machine, medical office building, or hospital) depend on the stream of usable cash flows that the asset is expected to produce. Because taxes reduce the cash flows that are usable to the business, financial analyses must include the impact of local, state, and federal taxes. Local and state tax laws vary widely, so we do not attempt to cover them in this text. Rather, we focus on the federal income tax system because these taxes dominate the taxation of business income. In our examples, we typically increase the effective tax rate to approximate the effects of state and local taxes.
Congress can change tax laws, and major changes have occurred every three to four years, on average, since 1913, when the federal tax system was initiated. Furthermore, certain aspects of the Tax Code are tied to inflation, so changes based on the previous year’s inflation rate automatically occur each year. Therefore, although this section gives you an understanding of the basic nature of our federal tax system, it is not intended to be a guide for application. Tax laws are so complicated that many law and business schools offer a master’s degree in taxation, and many who hold this degree are also certified public accountants. Managers and investors should rely on tax experts rather than trust their own limited knowledge. Still, it is important to know the basic elements of the tax system as a starting point for discussions with tax specialists. In a field complicated enough to warrant such detailed study, we can cover only the highlights.
14 Understanding Healthcare Finance Management
Current (2013) federal income tax rates on personal income go up to 39.6 percent, and when state and local income taxes are added, the marginal rate can approach 54 percent. Business income is also taxed heavily. The income from partnerships and proprietorships is reported by the individual owners as personal income and, consequently, is taxed at rates of up to 54 percent. Corporate income, in addition to state and local income taxes, is taxed by the federal government at marginal rates as high as 40 percent. Because of the magnitude of the tax bite, taxes play an important role in most financial management decisions made by individuals and by for-profit organizations.
Individual (Personal) Income Taxes Individuals pay personal taxes on wages and salaries; on investment income such as dividends, interest, and profits from the sale of securities; and on the profits of sole proprietorships, partnerships, and S corporations. For tax pur- poses, investors receive two types of income: (1) ordinary and (2) dividends and capital gains. Ordinary income includes wages and salaries and interest income. Dividend income (which arises from stock ownership) and capital gains (which arise from the sale of assets, including stocks) generally are taxed at lower rates than are ordinary income.
Taxes on Wages and Salaries Federal income taxes on ordinary income are progressive—that is, the higher one’s income, the larger the marginal tax, rate, which is the rate applied to the last dollar of earnings. Marginal rates on ordinary income begin at 10 percent; then rise to 15, 25, 28, and 35 percent; and finally top out at 39.6 percent. Because the levels of income for each bracket are adjusted for infla- tion annually, and because the brackets are different for single individuals and married couples who file a joint return, we do not provide a complete discussion here. In brief, in 2014 it takes a taxable income of $450,000 for married couples to be in the highest (39.6 percent) bracket, so most people fall into the lower brackets.
Taxes on Interest Income Individuals can receive interest income on savings accounts, certificates of deposit, bonds, and the like. Like wages and salaries, interest income is taxed as ordinary income and hence is taxed at federal rates of up to 39.6 percent, in addition to applicable state and local income taxes.
Note, however, that under federal tax laws, interest on most state and local government bonds, called municipals or munis, is not subject to fed- eral income taxes. Such bonds include those issued by municipal healthcare authorities on behalf of not-for-profit healthcare providers. Thus, investors
1
Chapter i: Introduction to Healthcare Financial Management 15
get to keep all of the interest received from municipal bonds but only a pro- portion of the interest received from bonds issued by the federal government or by corporations. Therefore, a lower interest rate muni bond can provide the same or higher after-tax return as a higher yielding corporate or Trea- sury bond. For example, consider an individual in the 35 percent federal tax bracket who can buy a taxable corporate bond that pays a 10 percent interest rate. What rate would a similar-risk muni bond have to offer to make the investor indifferent between it and the corporate bond?
Here is a way to think about this problem:
After-tax rate on corporate bond = Pretax rate - Yield lost to taxes
= Pretax rate - Pretax rate x Tax rate
= Pretax rate x (1 - T)
= 10% x (1 - 0.35) = 10% x 0.65 = 6.5%.
Here, Tis the investor’s marginal tax rate. Thus, the investor would be indifferent between a corporate bond with a 10 percent interest rate and a municipal bond with a 6.5 percent rate.
If the investor wants to know what yield on a taxable bond is equiva- lent to, say, a 7.0 percent interest rate on a muni bond, he would follow this procedure:
Equivalent rate on taxable bond = Rate on municipal bond / (1 - T)
= 7.0% / (1 - 0.35) = 7.0% / 0.65 - 10.77%.
The exemption of municipal bonds from federal taxes stems from the separation of power between the federal government and state and local gov- ernments, and its primary effect is to allow state and local governments (as well as not-for-profit healthcare providers) to borrow at lower interest rates than otherwise would be possible.
Dividend Income In addition to interest income on securities, investors can receive dividend income from securities (stocks). Because investor-owned corporations pay dividends out of earnings that have already been taxed, there is double taxa- tion on corporate income. Because taxes have already been paid on these earnings, dividend income is taxed at the same rates as long-term capital gains income; these rates are lower than those on ordinary and interest income. If an individual is in the 25 percent or higher tax bracket, dividends are taxed at 15 percent. If an individual is in the 10 or 15 percent tax bracket, dividends are taxed at only 5 percent. To see the advantage, consider an individual in
Understanding Healthcare Finance Management
the 35 percent tax bracket who receives both $100 in interest income and $100 in dividend income. The taxes on the interest income would be 0.35 x $100 = $35, while the taxes on the dividend income would be only 0.15 x $100 = $15, a difference of $20.5
Capital Gains Income Assets such as stocks, bonds, real estate, and property and equipment (land, buildings, X-ray machines, and the like) are defined as capital assets. If an individual buys a capital asset and later sells it at a profit—that is, if the indi- vidual sells it for more than the purchase price—the profit is called a capital gain. If the individual sells it for less than the purchase price, the loss is called a capital loss. An asset sold within one year of the time it was purchased pro- duces a short-term capital gain or loss, whereas an asset held for more than one year produces a long-term capital gain or loss. For example, if you buy 100 shares of Tenet Healthcare for $10 per share and sell the stock later for $15 per share, you will realize a capital gain of 100 x ($15 - $10) = 100 x $5 = $500. However, if you sell the stock for $5 per share, you will incur a capital loss of $500. If you hold the stock for one year or less, the gain or loss is short term; otherwise, it is a long-term gain or loss. Note that if you sell the stock for $10 a share, you will realize neither a capital gain nor loss; you will simply get your $1,000 back, and no taxes will be due on the transaction.
Short-term capital gains are taxed as ordinary income at the same rates as wages and interest. However, long-term capital gains are taxed at the same rates as dividends; these rates are lower than those on ordinary income. For an illustration of the effect of this tax benefit on long-term capital gains, consider an investor in the top 35 percent tax bracket who makes a $500 long-term capital gain on the sale of Tenet Healthcare stock. If the $500 were ordinary income, she would have to pay federal income taxes of 0.35 x $500 = $175. However, as a long-term capital gain, the tax would be only 0.15 x $500 = $75, for a savings of $100 in taxes. There are many nuances to capital gains taxes, especially regarding the effect of losses on taxes. Our purpose is merely to introduce the concept.
The purpose of the reduced tax rate on dividends and long-term capi- tal gains is to encourage individuals to invest in assets that contribute most to economic growth.
Corporate Income Taxes The corporate tax structure, shown in Exhibit 1.1, has marginal rates as high as 39 percent, which brings the average rate up to 35 percent. For example, if Midwest Home Health Services, an investor-owned home health care busi- ness headquartered in Chicago, had $80,000 of taxable income, its federal income tax bill would be $15,450:
Average Tax Rate at TopTaxable Income Tax of Bracket
Up to $50,000 15% of taxable income 15.0%
$5O,OOI-$75,OOO $7,500 + 25% of excess over $50,000 18.3%
$75,OOI-$IOO,OOO $13,750 + 34% of excess over $75,000 22.3%
$ioo,ooi-$335,°00 $22,250 + 39% of excess over $100,000 34.0%
$335,ooi-$io,ooo,ooo $113,900 + 34% of excess over $335,000 34.0%
$10,000,ooi-$i5,000,000 $3,400,000 + 35% of excess over $10,000,000
34-3%
$15,OOO,OOI-$I8,333,333 $5,150,000 + 38% of excess over $15,000,000
35.0%
Over $18,333,333 $6,416,667 + 35% of excess over $18,333,333 35.0%
EXHIBIT 1.1 Corporate Tax Rates for 2014
Corporate taxes = $13,750 + [0.34 x ($80,000 - $75,000)]
= $13,750 + (0.34 x $5,000)
= $13,750 + $1,700 = $15,450.
Midwest’s marginal tax rate would be 34 percent, but its average tax rate would be $15,450/$80,000 = 19.3%. Note that the average federal corporate income tax rate is progressive to $18,333,333 of income, but it is constant thereafter.
Unrelated Business Income Even though tax-exempt holding companies can be created with both tax- exempt and taxable subsidiaries, tax-exempt corporations can have taxable income, which is usually referred to as unrelated business income (UBI). UBI is created when a tax-exempt corporation has income from a trade or business that (1) is not substantially related to the charitable goal of the organization and (2) is carried on with the frequency and regularity of comparable for- profit commercial businesses.
As an example of UBI, consider Bayside Memorial Hospital’s phar- macy sales. In addition to its services to the hospital’s patients, the not-for- profit hospital’s pharmacy has a second location, adjacent to the parking garage, which sells drugs and supplies to the general public. In general, the Internal Revenue Service (IRS) views the charitable purpose of a hospital as providing healthcare services to its patients, so the income from Bayside’s sales of drugs and supplies to nonpatients is taxable. The fact that the profits
18 Understanding Healthcare Finance Management
from the sales are used for charitable purposes is immaterial. Note, however, that if the trade or business in which a not-for-profit entity is engaged (1) is run by volunteers, (2) is run for the convenience of its employees, or (3) involves the sale of merchandise contributed to the organization, the income generated remains tax exempt. Thus, the profits on Bayside’s sales of drugs and supplies to its employees, as well as the profits on the sale of items in its gift shop run by volunteers, are exempt from taxation.
Not-for-profit organizations must file UBI tax returns with the IRS annually if their gross income from unrelated business activity exceeds $1,000. Taxable income is determined by deducting expenses related to UBI income production from gross income. Then, taxes are calculated as if the income were earned by a taxable corporation.
Interest and Dividend Income Received by an Investor-Owned Corporation Interest income received by a taxable corporation is taxed as ordinary income at the regular tax rates contained in Exhibit 1.1. However, a portion of the dividends received by one corporation from another is excluded from taxable income. As we mention in our discussion of holding companies, the size of the dividend exclusion depends on degree of ownership. In general, we assume that corporations that receive dividends have only nominal ownership in the dividend-paying corporations, so 30 percent of the dividends received are taxable. The purpose of the dividend exclusion is to lessen the impact of triple taxation. Triple taxation occurs when the earnings of Firm A are taxed; then dividends are paid to Firm B, which must pay partial taxes on the income; and then Firm B pays out dividends to Individual C, who must pay personal taxes on the income.
To see the effect of the dividend exclusion, consider the following example. A corporation that earns $500,000 and pays a 34 percent marginal tax rate would have an effective tax rate of only 0.30 x 0.34 = 0.102 = 10.2% on its dividend income. If this firm had $10,000 in pretax dividend income, its after-tax dividend income would be $8,980:
After-tax income = Pretax income - Taxes
= Pretax income - (Pretax income x Effective tax rate)
= Pretax income x (1 - Effective tax rate)
= $10,000 x [1 - (0.30 x 0.34)]
= $10,000 x (1 - 0.102) = $10,000 x 0.898 = $8,980.
If a taxable corporation has surplus funds that can be temporarily invested in securities, the tax laws favor investment in stocks (which pay dividends) rather than in bonds (which pay interest). For example, suppose
Chapter i: Introduction to Healthcare Financial Management 19
Midwest Home Health Services has $100,000 to invest temporarily, and it tin buy either bonds that pay interest of $8,000 per year or preferred stock that pays dividends of $7,000 per year. Because Midwest is in the 34 percent tax bracket, its tax on the interest if it bought the bonds would be 0.34 x §8 000 = $2,720, and its after-tax income would be $8,000 - $2,720 = $5 280. If it bought the preferred stock, its tax would be 0.34 x (0.30 x $7 000) = $714, and its after-tax income would be $6,286. Other factors might lead Midwest to invest in the bonds or other securities, but the tax laws favor stock investments when the investor is a corporation.
Interest and Dividend Income Received by a Not-for-Profit Corporation Interest income and dividend income received from securities purchased by not-for-profit corporations with temporary surplus cash are not tax- able. However, note that not-for-profit firms are prohibited from issuing tax-exempt bonds for the sole purpose of reinvesting the proceeds in other securities, although they can temporarily invest the proceeds from a tax- exempt issue in taxable securities while waiting for the planned expenditures to occur. If not-for-profit firms could engage in such tax arbitrage operations, they could, in theory, generate an unlimited amount of income by issuing tax-exempt bonds for the sole purpose of investing in higher-yield securities that are taxable to most investors. For example, a not-for-profit firm might sell tax-exempt bonds with an interest rate of 5 percent and use the proceeds to invest in US Treasury bonds that yield 6 percent.
Interest and Dividends Paid by an Investor-Owned Corporation A firm’s assets can be financed with either debt or equity capital. If it uses debt financing, it must pay interest on that debt, whereas if an investor- owned firm uses equity financing, normally it will pay dividends to its stock- holders. The interest paid by a taxable corporation is deducted from the cor- poration’s operating income to obtain its taxable income, but dividends are not deductible. Put another way, dividends are paid from after-tax income. Therefore, Midwest, which is in the 34 percent tax bracket, needs only $1 of pretax earnings to pay $1 of interest expense, but it needs $1.52 of pretax earnings to pay $1 in dividends:
$1 Dollars of pretax income required =----------— -------- -
(1 - Tax rate)
The fact that interest is a tax-deductible expense, while dividends are not, has a profound impact on the way taxable businesses are financed. The
20 Understanding Healthcare Finance Management
US tax system favors debt financing over equity financing. This point is dis- cussed in detail in Chapter 10.
Corporate Capital Gains At one time, corporate long-term capital gains were taxed at lower rates than were ordinary income. However, under current law, corporate capital gains are taxed at the same rate as operating income.
Corporate Loss Carry-Back and Carry-Forward Corporate operating losses that occur in any year can be used to offset taxable income in other years. In general, such losses can be carried back to each of the preceding two years and forward for the next 20 years. For example, an operating loss by Midwest Home Health Services in 2014 would be applied first to 2012. If Midwest had taxable income in 2012 and hence paid taxes, the loss would be used to reduce 2012’s taxable income, so the firm would receive a refund on taxes paid for that year. If the 2014 loss exceeded the taxable income for 2012, the remainder would be applied to reduce taxable income for 2013. If Midwest did not have to use the 2014 loss to offset 2013 or 2012 profits, the loss for 2014 would be carried forward to 2015, 2016, and so on—up to 2034. Note that losses that are carried back provide imme- diate tax benefits, but the tax benefits of losses that are carried forward are delayed until sometime in the future. The tax benefits of losses that cannot be used to offset taxable income in 20 years or less are lost to the firm. The purpose of this provision in the tax laws is to avoid penalizing corporations whose incomes fluctuate substantially from year to year.
Consolidated Tax Returns As we mention later, if a corporation owns 80 percent or more of another corporation’s stock, it can aggregate income and expenses and file a single consolidated tax return. Thus, the losses of one firm can be used to offset the profits of another. No business wants to incur losses (it can go broke los- ing $1 to save 34 cents in taxes), but tax offsets do make it more feasible for large multicompany businesses to undertake risky new ventures that might suffer start-up losses.
SELF-TEST QUESTIONS 1. Briefly explain the individual (personal) and corporate income tax
systems. 2. What is the difference in individual tax treatment between interest
and dividend income? 3. What are capital gains and losses, and how are they differentiated
from ordinary income?
Chapter 1: Introduction to Healthcare Financial Management 21
4. What is unrelated business income? 5 How do federal income taxes treat dividends received by
corporations compared to dividends received by individuals? 6. With regard to investor-owned businesses, do tax laws favor financing by debt or by equity? Explain your answer.
SELF-TEST QUESTIONS
Depreciation
A fundamental accounting concept is the matching principle, which requires expenses to be recognized in the same period as the related revenue is earned. Suppose Northside Family Practice buys an X-ray machine for $100,000 and uses it for ten years, after which time the machine becomes obsolete. The cost of the services provided by the machine must include a charge for the cost of the machine; this charge is called depreciation. Depreciation reduces profit (net income) as calculated by accountants, so the higher a business’s depreciation charge, the lower its reported profit. However, depreciation is a noncash charge—it is an allocation of previous cash expenditures—so higher depreciation expense does not reduce cash flow. In fact, higher depreciation increases cash flow for taxable businesses because the greater a business’s depreciation expense in any year, the lower its tax bill.
To see more clearly how depreciation expense affects cash flow, consider Exhibit 1.2. Here, we examine the impact of depreciation on two investor-owned hospitals that are alike in all regards except for the amount of depreciation expense each hospital has. Hospital A has $100,000 of deprecia- tion expense, has $200,000 of taxable income, pays $80,000 in taxes, and has an after-tax income of $120,000. Hospital B has $200,000 of depreciation
Hospital A Hospital B EXHIBIT 1.2 The Effect of
Revenue $1,000,000 $1,000,000 Depreciation on Cash Flow
Costs except depreciation 700,000 700,000 Depreciation 100,000 200,000 Taxable income $ 200,000 $ 100,000
Federal plus state taxes (assumed to be 40%) 80,000 40,000
After-tax income $ 120,000 $ 60,000 Add back depreciation 100,000 200,000 Net cash flow $ 220,000 $ 260.000
22 Understanding Healthcare Finance Management
expense, has $100,000 of taxable income, pays $40,000 in taxes, and has after-tax income of $60,000.
Depreciation is a noncash expense, whereas we assume that all other entries in Exhibit 1.2 represent actual cash flows. To determine each hospi tai’s cash flow, depreciation must be added back to after-tax income. Wher this is done, Hospital B, with the larger depreciation expense, has the largei cash flow. In fact, Hospital B’s cash flow is larger by $260,000 - $220,00( = $40,000, which represents the tax savings, or tax shield, on its additional $100,000 in depreciation expense:
Tax shield = Tax rate x Depreciation expense = 0.40 x $100,000 = $40,000.
Because a business’s financial condition depends on the actual of cash it earns, as opposed to some arbitrarily determined accounting profit, owners and managers should be more concerned with cash flow than with reported profit. Note that if the hospitals in Exhibit 1.2 were not-for- hospitals, taxes would be zero for both, and they would have $300,00C in net cash flow. However, Hospital A would report $200,000 in earnings, while Hospital B would report $100,000 in earnings.
For-profit businesses generally calculate depreciation one way for tax returns and another way when reporting income on their financial state- ments. For tax depreciation, businesses must follow the depreciation guide- lines laid down by tax laws, but for other purposes, businesses usually accounting, or depreciation guidelines.
The most common method of determining book depreciation is the straight-line method. To apply the straight-line method, (1) start with the capitalized cost of the asset (generally, price plus shipping plus installation); (2) subtract the asset’s salvage value, which, for book purposes, is the esti- mated value of the asset at the end of its useful life; and (3) divide the net amount by the asset’s useful life. For example, consider Northside’s X- machine, which cost $100,000 and has a ten-year useful life. Furthermore, assume that it cost $10,000 to deliver and install the machine and that its estimated salvage value after ten years of use is $5,000. In this case, the capi- talized cost, or basis, of the machine is $100,000 + $10,000 = $110,000, and the annual depreciation expense is ($110,000 - $5,000)/10 = $10,500. Thus, the depreciation expense reported on Northside’s income statement would include a $10,500 charge for wear and tear on the X-ray machine. The name “straight line” comes from the fact that the annual depreciation under this method is constant. The book value of the asset, which is the cost minus the accumulated depreciation to date, declines evenly (follows a straight line) over time.
For tax purposes, depreciation is calculated according to the Modi- fied Accelerated Cost Recovery System (MACRS). MACRS spells out two
Chapter 1: Introduction to Healthcare Financial Management 23
rocedures for calculating tax depreciation: (1) the standard (accelerated) ^method which is faster than the straight-line method because it allows busi- nesses to depreciate assets on an accelerated basis, and (2) an alternative straight-line method, which is optional for some assets but mandatory for oth- ers Because taxable businesses want to gain the tax shields from depreciation as quickly as possible, they normally use the standard (accelerated) MACRS method when it is allowed.
The calculation of MACRS depreciation uses three components: (1) the depreciable basis of the asset, which is the total amount to be depreci- tted; (2) a recovery period that defines the length of time over which the asset is depreciated; and (3) a set of allowance percentages for each recovery period, which, when multiplied by the basis, gives each year’s depreciation
expense.
Depreciable Basis The depreciable basis is a critical element of the depreciation calculation because each year’s recovery allowance depends on the asset’s depreciable basis and its recovery period. The depreciable basis under MACRS gener- ally is equal to the purchase price of the asset plus any transportation and installation costs. Unlike the calculation of book depreciation, the basis for MACRS depreciation is not adjusted for salvage value regardless of whether the standard accelerated method or alternative straight-line method is used.
AMC/?S Recovery Periods Exhibit 1.3 describes the general types of property that fit into each recovery period. Property in the 27.5- and 39-year classes (real estate) must be depre- ciated using the alternate straight-line method, but 3-, 5-, 7-, and 10-year property (personal property) can be depreciated by either the standard accel- erated method or the alternative straight-line method.
Period Type of Property ' EXHIBIT 1.3
MACRS
3-year Tractor units and certain equipment used in research Recovery
Periods 5-year Automobiles, trucks, computers, and certain special
7-year manufacturing tools
Most equipment, office furniture, and fixtures 10-year Certain longer-lived types of equipment 27.5-year Residential rental property, such as apartment buildings 39-year All nonresidential property, such as commercial and industrial
buildings
Note: Land cannot be depreciated.
24 Understanding Healthcare Finance Management
MACRS Recovery Allowances Once the property is placed in the correct recovery period, the yearly recov- ery allowance, or depreciation expense, is determined by multiplying the asset’s depreciable basis by the appropriate recovery percentage shown in Exhibit 1.4. The calculation is discussed in the following sections.
Under MACRS, it is generally assumed that an asset is placed in ser- vice in the middle of the first year. Thus, for 3-year recovery period property, depreciation begins in the middle of the year the asset is placed in service and ends three years later. The effect of the half-year convention is to extend the recovery period one more year, so 3-year property is depreciated over four calendar years, 5-year property is depreciated over six calendar years, and so on. This convention is incorporated in the values listed in Exhibit 1.4.
MACRS Depreciation Illustration Assume that the $100,000 X-ray machine is purchased by Northside Family Practice and placed in service in 2014. Furthermore, assume that Northside paid another $10,000 to ship and install the machine and that the machine falls into the MACRS 5-year class. Because salvage value does not play a part in tax depreciation, and because delivery and installation charges are included (are capitalized) in the basis rather than expensed in the year incurred, the machine’s depreciable basis is $110,000.
Each year’s recovery allowance (tax depreciation expense) is deter- mined by multiplying the depreciable basis by the applicable recovery
EXHIBIT 1.4 ----------------------------------------------------------------------------------------------------------------- MACRS Ownership Recovery Period
Recovery Allowances Year 3-Year 5-Year 7-Year io-Year
I 33% 20% 14% 10%
2 45 32 25 18 3 15 19 17 14 4 7 12 13 12 5 11 9 9 6 6 9 7 7 9 7 8 4 7 9 7 10 6 li
100% 100% 100% 100%
Note: The tax tables carry the recovery allowances to two decimal places, but for ease of illus- tration, we will use the rounded allowances shown in this table throughout this text.
Chapter 1: Introduction to Healthcare Financial Management 25
'■ntage. Thus, the depreciation expense for 2014 is 0.20 x $110,000 ^$22 000, and for 2015 it is 0.32 x $110,000 = $35,200. Similarly, the depreciation expense is $20,900 for 2016, $13,200 for 2017, $12,100 for 7018 and $6,600 for 2019. The total depreciation expense over the six-year recovery period is $110,000, which equals the depreciable basis of the X-ray machine Note that the depreciation expense reported for tax purposes each year is different from the book depreciation reported on Northside’s income statement, which we calculated earlier.
The book value of a depreciable asset at any point in time is its depre- ciable basis minus the depreciation accumulated to date. Thus, at the end of 2014, the X-ray machine’s tax book value is $110,000 - $22,000 = $88,000; at the end of 2015, the machine’s tax book value is $110,000 - $22,000 - $35,200 =■= $52,800 (or $88,000 - $35,200 = $52,800); and so on. Again, note that the book value for accounting purposes is different from the book
value for tax purposes. According to the IRS, the value of a depreciable asset at any point in
time is its tax book value. If a business sells an asset for more than its tax book value, the implication is that the firm took too much depreciation, and the IRS will want to recover the excess tax benefit. Conversely, if an asset is sold for less than its book value, the implication is that the firm did not take suf- ficient depreciation, and it can take additional depreciation on the sale of the asset. For example, suppose Northside sells the X-ray machine in early 2016 for $60,000. Because the machine’s tax book value is $52,800 at the time, $60,000 - $52,800 = $7,200 is added to Northside’s operating income and taxed. Conversely, if Northside received only $40,000 for the machine, it would be able to deduct $52,800 - $40,000 = $12,800 from taxable income and hence reduce its taxes in 2016.
1. Briefly describe the MACRS tax depreciation system. 2. What is the effect of the sale of a depreciable asset on a firm’s
taxes?
SELF-TEST QUESTIONS
Health Reform and Financial Management
The Patient Protection and Affordable Care Act (ACA) of 2010 has been called the “most significant health care legislation since Medicare and Med- icaid in 1965.” The new law was enacted on March 23, 2010, and was designed to provide all US citizens and legal residents with access to afford- able health insurance, to reduce healthcare costs, and to improve care and quality. This legislation puts in place comprehensive health insurance changes to expand coverage, hold insurance companies accountable, lower costs,
26 Understanding Healthcare Finance Management
guarantee more choices, and enhance the quality of care—all of which are intended to transform and make the US healthcare system more sustainable.
The ACA has numerous major aims. However, the central goal is to expand healthcare coverage through shared responsibility between govern- ment, individuals, and employers. This involves requiring all US citizens and legal residents to have health insurance coverage, which may be acquired through health insurance exchanges at affordable or income-based costs (if they are self-employed, they are unemployed, or their employers do not offer insurance). Employers are required to offer direct coverage to employees or indirect coverage through the provision of tax credits. Public programs such as Medicare and Medicaid have expanded eligibility requirements to cover qualified individuals and families with incomes less than 133 percent of the federal poverty level. These changes are intended to reduce the number of uninsured by half and provide coverage for about 94 percent of Americans. In addition, these reforms are intended to reduce healthcare expenditures by $100 billion in the next ten years by controlling overspending, waste, fraud, and abuse.
Some of the benefits of the ACA include free preventive care, no preexisting-condition limitation, prescription discounts for seniors, protec- tion against healthcare fraud, small-business tax credits, extended coverage for young adults, lifetime coverage on most benefits, prevention of cover- age cancellation, transparency on increases in insurance premium rates, and patient selection of primary care doctors from network.
The major implications of health reform for health insurance and provider payments are addressed in chapters 2 and 3, respectively. The major implications of health reform for the institutional setting and the delivery of healthcare services are discussed in this section.
Accountable Care Organizations An accountable cave organization (ACO) is one of the ways the ACA seeks to decrease healthcare costs. An ACO is a network of doctors, other clinicians, and hospitals and clinics that shares responsibility for providing coordinated care to patients. Providers in an ACO are not only jointly accountable for the health of their patients but also receive financial incentives to cooperate and save money by avoiding unnecessary tests and procedures, eliminating duplication of services, and coordinating patients’ care.
ACOs can include hospitals, specialists, post-acute providers, and even private companies. The only required member of an ACO is a primary care physician, who serves as the lead of the program. More than half of the Medicare ACOs that exist today are run by physicians and do not include a hospital partner.
An ACO can take on many forms, such as the following:
Chapter 1: Introduction to Healthcare Financial Management 27
An integrated delivery system that has common ownership of hospitals and physician practices and has electronic medical records, team-based care, and resources to support cost-effective care
• A multispecialty group practice that has strong affiliations with hospitals and contracts with multiple health plans
• A physician-hospital organization that is a subset of a hospital’s medical staff and that functions like a multispecialty group practice
• An independent practice association comprising individual physician practices that come together to contract with health plans
• A virtual physician organization that sometimes includes physicians in rural areas
ACOs are paid through the traditional fee-for-service system; however, they are offered bonuses as an incentive to keep costs of care down. Doctors and hospitals have to meet specific quality benchmarks that focus on pre- vention and carefill management of patients with chronic diseases. In other words, providers get paid more for keeping patients healthy and out of the hospital. If an ACO is unable to save money, it could be liable for the costs of the investments made to improve care; it also may have to pay a penalty if it does not meet performance and savings benchmarks. The US Department of Health and Human Services estimates that ACOs could save Medicare up to $940 million in the first four years of their operation.
Industry Consolidation Health reform is driving the consolidation of healthcare organizations. The ACA has accelerated health systems’ acquisition of hospitals and hospitals’ acquisition of physician practices, and that is likely to continue over the next several years. With the greater focus on clinical integration, quality patient care, and changing reimbursement, healthcare organizations are seeking to restructure healthcare delivery to operate more efficiently and improve coordination between patients and providers. Healthcare organizations are looking to gain a competitive advantage from combining assets, staff, and resources. Consolidation not only provides organizations access to capital, economies of scale, and market share but may also lead to improvement in patient care by making it easier to share patient information, adhere to clinical practice guidelines (thus reducing variations in care), and access high- quality specialist physicians.
Population Health Health reform is moving providers toward the population health management approach. The goal of population health management is to shift from focus- lng on treating illness to maintaining or improving health to prevent costly
28 Understanding Healthcare Finance Management
avoidable illness and unnecessary care, which is supported by new reimburse- ment models like capitation, payment bundling, and shared savings. Instead of just providing preventive and chronic care when patients come in for acute problems, practices track and monitor the health status of the entire patient population, requiring greater use of health information technology. The key to success in population health management will be greater awareness of the health status of the population and proactive intervention to reduce use of the health system and to achieve the best population outcomes.
Clinical Integration A fundamental component to achieving the goals of the ACA and other health reform efforts is clinical integration. Clinical integration aims to coor- dinate patient care across conditions, providers, settings, and time to achieve care that is safe, timely, effective, efficient, and patient focused. New payment models and advances in health information systems are used to facilitate the transition to the clinical integration model and to manage the continuum of care for patients. Provider payments are tied to results for quality, access, and efficiency with the objective of establishing coordination between hos- pitals and physicians. Health information technology aims to capture patient information and make it accessible to authorized providers at the point of care. Complete patient information facilitates optimal treatment strategies and reduces the chance of medication errors and conflicting treatment plans. There will be requirements for new and more comprehensive policies and procedures that protect patient privacy and that guarantee secure data that are transferred between patients, caregivers, and organizations.
Data Analytics ACOs and an increasing emphasis on collaboration between clinicians and on quality patient care are making it necessary for healthcare organizations to invest in integrated information systems technology to collect large quantities of patient and provider data (so-called big data). Data analytic systems are capable of analyzing large amounts of patient data to better understand clini- cal processes and to identify problems and opportunities for improvement in the provision of healthcare services. Complex, new information technology will facilitate analysis of care coordination, patient safety, and utilization of healthcare services.
Staffing Shortages Health reform is expected to increase the number of patients who can access the healthcare system. Healthcare organizations will see an influx of formerly uninsured patients now seeking care because they have insurance or better coverage. As a result, the demand for healthcare professionals—especially physicians, nurse practitioners, and physician assistants—will likely increase.
Chapter i: Introduction to Healthcare Financial Management 29
Health reform is also driving changes in hospital staffing by emphasiz- ing prevention and value-based care, creating demand for primary care pro- viders, emergency physicians, clinical pharmacists, and health information technology and data specialists. Some professional and industry associations are predicting that current shortages of various healthcare staff will worsen in the face of this growing demand. The ACA has identified several strategies to increase the supply of health professionals (including primary care physi- cians), such as scholarships and flexible loan repayment programs. However, many healthcare organizations likely will face great competition for some healthcare staff.
1. Briefly describe the major changes under the ACA. 2. What are the major implications of health reform for financial
management of healthcare organizations?
SELF-TEST QUESTIONS
Chapter Key Concepts This chapter presented some background information on business orga- nization, ownership, goals, and taxes. Here are its key concepts:
• Financial management is a decision science, so the primary objective of this text is to provide students and practicing healthcare managers with the theory, concepts, and tools necessary to make effective decisions. The text is structured to support this goal.
• The primary role of financial management is to plan for, acquire, and utilize funds to maximize the efficiency and value of an enterprise.
• Financial management functions include (1) evaluation and planning, (2) long-term investment decisions, (3) financing decisions, (4) working capital management, (5) contract management, and (6) financial risk management.
• Although each form of organization has unique advantages and disadvantages, most large organizations and all not-for-profit entities are organized as corporations.
• From a financial management perspective, the goal of investor- owned firms is shareholder wealth maximization, which translates to stock price maximization. For not-for-profit firms, a reasonable goal for financial management is to ensure the organization can
(continued)
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(continued from previous page) fulfill its mission, which translates to maintaining the organization’s financial viability.
• An agency problem is a potential conflict of interest between principals and agents. One type of agency problem that can arise in financial management is conflict between the owners and managers of a for-profit corporation.
• The value of any income stream depends on the amount of usable, or after-tax, income. Thus, tax laws play an important role in financial management decisions.
• Separate tax laws apply to personal income and corporate income. • Fixed assets are depreciated, over time to reflect the decline in their
values. Depreciation is a deductible, but noncash, expense. Thus, for a taxable entity, the higher its depreciation, the lower its taxes and hence the higher its cash flow, with other things held constant.
• Current laws specify that the Modified Accelerated Cost Recovery System (MACRS) be used to depreciate assets for tax purposes.
• The Patient Protection and Affordable Care Act (ACA) of 2010 aims to provide all US citizens and legal residents with access to affordable health insurance options and to transform the healthcare system to reduce costs.
• Accountable care organizations (ACOs) are one of the ways the ACA seeks to reduce healthcare costs. This type of organization is made up of a network of doctors, other clinicians, and hospitals and clinics that shares responsibility for providing coordinated care to patients with the intention of reducing unnecessary spending.
Although this chapter provides a great deal of background infor- mation relevant to healthcare financial management and the changes associated with health reform, it is necessary to have a more thorough understanding of the reimbursement system. This important topic is covered in Chapter 2.
Chapter Models, Problems, and Mini-Cases
This chapter does not have an accompanying spreadsheet model. However, the chapter has five problems in spreadsheet format that focus on tax issues.
The problem spreadsheets can be accessed on this book’s companion website at ache.org/books/UHFM7.
Chapter 1: Introduction to Healthcare Financial Management 31
Selected Bibliography
Allen S , and M. Bombardieri. 2008. “A Healthcare System Badly Out of Balance.” Boston Globe, November 16.
Buntin, M. B., S. H. Jain, and D. Blumenthal. 2010. “Patient Protection and Afford- able Care Act.” Health Affairs 29 (6): 1214-219.
Burke, T. 2011. “Accountable Care Organizations.” Public Health Reports 126 (6):
875.
Carlson, J. 2009. “Grassley, Bingaman Push Charity Care Standards.” Accessed May 6, 2010. www.modernhealtlicare.com/article/20090206/REG/302069970 &Template=printpicart.
DeVore, S., and R. W. Champion. 2011. “Driving Population Health Through Accountable Care Organizations.” Health Affairs 30 (1): 41-50.
Emanuel, E. J. 2012. “Where Are the Health Care Cost Savings?” JAMA 307 (1): 39-40.
Fisher, E. S., and S. M. Shortell. 2010. “Accountable Care Organizations.” JAMA 304 (15): 1715-716.
Gleckman, H. 2012. “NYU/UCLA Tax Policy Conference Tax Law and Healthcare Reform: Healthcare and the Long-Term Fiscal Outlook.” Tax Law Review 65: 835-35.
Hcarle, K. 2009. “Strategies for Accurate Community Benefit Reporting.” Health- care Financial Management 63 (2): 56-61.
Langabeer II, J., J. DelliFraine, and J. Helton. 2010. “The Current State of Finance and Account Management in the Healthcare Industry.” Montvale, NJ: Insti- tute of Management Accountants.
Patton, T. L. 2009. “The IRS’s Version of Community Benefit: A Look at the Rede- signed Form 990 and New Schedule H.” Healthcare Financial Management 63 (2): 50-54.
Singer, S., and S. M. Shortell. 2011. “Implementing Accountable Care Organiza- tions.” JAMA 306 (7): 758.
Speizman, R. A. 2009. “Tax-Exempt Status for Hospitals: Where Have We Been— and Where Are We Going?” Healthcare Financial Management 63 (2): 62-66. . 2008. “The New Form 990: Taking a Closer Look.” Healthcare Financial Management 62 (4): 82-87.
Speizman, R. A., and A. Mitchell. 2013. “Keeping Step with IRS Guidance on Requirements for Tax-Exempt Hospitals.” Healthcare Financial Management 67 (9): 114-18.
Tax Policy Center. 2009. “Tax Policy Report Card: 5-Year Carryback of Net Oper- ating Losses.” Accessed May 6, 2010. www.taxpolicycenter.org/taxtopics/ senate_net_operating_losses.cfm.
32 Understanding Healthcare Finance Management
Wong-Hammond, L., and L. Damon. 2013. “Financing Strategic Plans for Not-for-
Profits.” Healthcare Financial Management 67 (7): 70-76.
Selected Websites
The following websites pertain to the content of this chapter:
• For more information on taxes, go to www.taxfoundation.org. • To get a feel for the services offered by a corporate alliance, see the
VHA site at www.vha.com. • Two of the largest integrated health systems in the United States
are Kaiser Permanente and the Henry Ford Health System. To gain a better idea of what constitutes such systems, visit www. kaiserpermanente.org or www.henryfordhealth.org.
• For more information on health reform, go to wvw.whitehouse.gov/ healthreform.
• For more information on the Affordable Care Act and accountable care organizations, go to www.accountablecarefacts.org.
Notes
1. Not-for-profit organizations are also called nonprofit organizations, but the former designation is becoming dominant in the health services industry. Also, investor-owned businesses are sometimes called proprietary, or for-profit, businesses.
2. There is a set of questions for each case in the online Instructor’s Resources that accompany the casebook. Instructors who want to provide more guidance to students than that given in the case itself can distribute these questions to their students.
3. For additional information see, www.ache.org/pubs/Releases/2014/ top-issues-confronting-hospitals-2013.cfm.
4. Not-for-profit organizations also use incentive compensation plans. For more information, see Ackerman, K., W. E. Kibler Jr., G. D. Steele Jr., R. L. Van Horn, and K. Swartz. 2005. “Executive Compensation in Nonprofit Health Care Organizations.” Inquiry 42 (2): 110-17.
5. Tax rates are constantly changing, so it is important to ensure that the tax rates used for real-world financial decision making are current.
CHAPTER SUPPLEMENT
FORMS OF BUSINESS ORGANIZATION, OWNERSHIP, AND STRUCTURE
Supplement Learning Objectives After studying this chapter supplement, readers should be able to
• describe the basic forms of business organization along with their advantages and disadvantages, and
• discuss the two basic types of ownership and explain why- ownership type is important when making financial management decisions.
Forms of Business Organization
There are four primary forms of business organization-. (1) proprietorship, (2) partnership, (3) corporation, and (4) hybrid. Most healthcare managers work for corporations and because not-for-profit businesses are organized as corporations, this supplement emphasizes this form. However, many indi- vidual physician practices are organized as proprietorships, and partnerships are common in group practices and joint ventures. In addition, hybrids are becoming more prevalent among physician practices. Healthcare managers must be familiar with all forms of business organization.
Proprietorship A proprietorship—sometimes called a sole proprietorship—is a business owned by one individual. Going into business as a proprietor is easy: The owner merely begins business operations. However, most cities require even the smallest businesses to be licensed, and state licensure is required of most healthcare professionals.
The proprietorship form of organization is easily and inexpensively formed, is subject to few governmental regulations, and pays no corporate income taxes. All earnings of the business—whether reinvested in the busi- ness or withdrawn by the owner—are taxed as personal income to the propri- etor. In general, sole proprietorships pay lower total taxes than comparable, taxable corporations do because corporate profits are taxed twice—once at
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the corporate level and once by stockholders at the personal level when prof- its are distributed as dividends or when capital gains are realized.
Partnership A partnership is formed when two or more individuals associate to conduct
a nonincorporated business. Partnerships operate under different degrees of formality, ranging from informal, verbal understandings to formal agree- ments filed with the state in which the partnership does business. Like propri- etorships, partnerships are inexpensive and easy to form. In addition, the tax treatment of partnerships is similar to that of proprietorships; a partnership’s earnings are allocated to the partners and taxed as personal income regard- less of whether the earnings are paid out to the partners or retained in the business.1
Proprietorships and partnerships have three important limitations:
1. It is usually difficult for owners to sell or transfer their interest in the business. 2. The owners have unlimited personal liability for the debts of the
business, which can result in losses greater than the amount invested in the business. In a proprietorship, unlimited liability means that the owner is personally responsible for the debts of the business. In a partnership, it means that if any partner is unable to meet his pro rata obligation in the event of bankruptcy, the remaining partners are responsible for the unsatisfied claims and must draw on their personal assets if necessary. 3. The life of the business is limited to the life of the owners.
From a finance perspective, these three disadvantages—difficulty in transferring ownership, unlimited liability, and impermanence of the busi- ness—lead to a fourth major disadvantage: It is difficult for proprietors and partners to attract substantial amounts of capital (raise money for the busi- ness). This difficulty is not a particular problem for a slow-growing busi- ness or when the owners are wealthy, but for most businesses, it becomes a handicap if the business needs to expand rapidly to take advantage of market opportunities. For this reason, proprietorships and most partnerships are small businesses.2 However, almost all businesses start as sole proprietor- ships, partnerships, or hybrids and then convert to the corporate form if large amounts of capital are needed.
Corporation A corporation is a legal entity that is separate and distinct from its owners and
managers. Although corporations can be investor owned or not-for-profit,
Chapter 1 Supplement: Forms of Business Organization, Ownership, and Structure 35
this section focuses on investor-owned corporations. The unique features of not-for-profit corporations are discussed in later sections. The creation of a separate business entity gives the corporation three main advantages:
1 A corporation has an unlimited lifespan and can continue in existence after its original owners and managers have died or left the firm.
2. It is easy to transfer ownership in a corporation because ownership is divided into shares of stock that can be easily sold.
3. Owners of a corporation have limited liability.
To gain an understanding of limited liability, suppose that one person made an investment of $10,000 in a partnership that subsequently went bankrupt and owed $100,000. Because the partners are liable for the debts of the partnership, that partner can be assessed a share of the partnership’s debt in addition to the initial $10,000 contribution. If the other partners are unable to pay their shares of the debt, one partner would be held liable for the entire $100,000. If the $10,000 had been invested in a corporation that went bankrupt, the loss for the investor would be limited to the initial $10,000 investment. (In the case of small, financially weak corporations, the limited liability feature of ownership is often fictitious because bankers and other lenders require personal guarantees from the stockholders.) With these three factors—unlimited life, ease of ownership transfer, and limited liabil- ity—corporations can more easily raise money in the financial markets than sole proprietorships or partnerships can.3
The corporate form of organization has two primary disadvantages. First, corporate earnings of taxable entities are subject to double taxation— once at the corporate level and once at the personal level, when dividends are paid to stockholders or capital gains are realized. Second, setting up a corpo- ration, and then filing the required periodic state and federal reports, is more costly and time-consuming than establishing a proprietorship or partnership.
Although a proprietorship or partnership can begin operations with- out much legal paperwork, setting up a corporation requires that the found- ers, or their attorney, prepare a charter and a set of bylaws. Today, attorneys have standard forms for charters and bylaws, so they can set up a no-frills corporation with much less work than that required to do so in the past. In addition, required forms are available online so that founders can do the work themselves. Still, setting up a corporation remains relatively difficult when compared to setting up a proprietorship or partnership, and it is even more difficult if the corporation has nonstandard features.
The charter includes the name of the corporation, its proposed activities, the amount of stock to be issued (if investor owned), and the
number and names of the initial set of directors. The charter is filed with the
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appropriate official of the state in which the business will be incorporated When the charter is approved, the corporation officially exists.4 After the cor- poration has been officially formed, it must file quarterly and annual financial and tax reports with state and federal agencies.
Bylaws are a set of rules drawn up by the founders to provide guid- ance for the governing and internal management of the corporation. Bylaws include information about how directors are to be elected, whether the exist- ing shareholders have the first right to buy new shares that the firm issues, and the procedures for changing the charter or bylaws.
For the following three reasons, the value of any investor-owned busi- ness, other than a very small one, generally is maximized if it is organized as a corporation:
1.Limited liability reduces the risks borne by equity investors (the owners); in general, the lower the risk, the higher the value of the investment.
2. A business’s value is dependent on growth opportunities, which in turn are dependent on the business’s ability to attract capital. Because corporations can obtain capital more easily than other forms of business can, they are better able to take advantage of growth opportunities.
3. The value of any investment is affected by its liquidity, which means the ease with which the investment can be sold for a fair price. Because an equity investment in a corporation is much more liquid than a similar investment in a proprietorship or partnership, the corporate form of organization creates more value for its owners.
Hybrid Although the three traditional forms of organization—proprietorship, part- nership, and corporation—dominated the business scene for decades, busi- nesses are now using several hybrids. Several of these forms have become popular in the health services industry.
There are specialized types of partnerships that have characteristics somewhat different from those of a standard partnership. For example, in a limited partnership, certain partners are designated general partners and oth- ers limited partners. The limited partners, like the owners of a corporation, are liable only for the amount of their investment in the partnership, while the general partners have unlimited liability. However, the limited partners typically have no control; it rests solely with the general partners. Limited partnerships are common in real estate and mineral investments. They are not as common in the health services industry because in this setting it is difficult to find one partner who is willing to accept all of the business’s risk and a second partner who is willing to relinquish all control.
Chapter 1 Supplement: Forms of Business Organization, Ownership, and Structure 37
The limited liability partnership (LLP) is a type of partnership in which the partners have joint liability for all actions of the partnership, including personal injuries and indebtedness. However, all partners enjoy limited liabil- ity regarding professional malpractice because they are liable only for their own malpractice actions, not those of the other partners. In spite of limited malpractice liability, the partners are jointly liable for the partnership’s debts. Menomonee Falls Ambulatory Surgery Center in Wisconsin is an example of an LLP (www.mfasc.com).
The limited liability company (LLC) is another type of hybrid business organization. It has some characteristics of a partnership and a corporation. The owners of an LLC are called members, and they are taxed as if they were partners in a partnership. However, a member’s liability is like that of a stock- holder of a corporation because liability is limited to the member’s initial contribution in the business. Personal assets are at risk only if the member assumes specific liability—for example, the member signs a personal loan guarantee. Ardent Health Services (www.ardenthealth.com), an organization with 12 acute care hospitals, a health plan, and almost 12,000 employees, is an example of an LLC. The LLP and LLC are complex types of hybrid orga- nization, so setting them up can be time-consuming and costly.
The professional corporation (PC), called a professional association (PA) in some states, is a form of organization common among physicians and other individual and group practice healthcare professionals. All 50 states have statutes that prescribe the requirements for such corporations, which provide the usual benefits of incorporation but do not relieve the partici- pants of professional liability. Indeed, the primary motivation behind the PC, which is a relatively old business form compared to the LLP and LLC, was to provide a way for professionals to incorporate yet still be held liable for professional malpractice. PCs have tight restrictions. First, one or more own- ers must be licensed in the profession of the PC. Second, PCs are taxed as corporations; they cannot be designated as an S corporation for tax purposes (see the following paragraph). Paragon Health PC (www.paragonhealthpc. com), a multispecialty group practice located in southwest Michigan, is an example of a PC.
For tax purposes, standard for-profit corporations are called C corpo- rations. If certain requirements are met, either one or a few individuals can incorporate but, for tax purposes only, elect to be treated as if the business were a proprietorship or partnership. Such corporations, which differ only in how the owners are taxed, are called S corporations. Although S corporations are similar to LLPs and LLCs regarding taxes, LLPs and LLCs afford owners more flexibility and benefits. For these reasons, many businesses—especially group practices—are converting to these newer forms.
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SELF-TEST QUESTIONS 1.
2. 3.
What are the four forms of business organization, and how do they differ? What are some different types of partnerships? What are some different types of corporations?
Alternative Forms of Ownership
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Unlike other sectors in the economy, not-for-profit corporations play a major role in the healthcare sector, especially among providers. For example, only 20 percent of nongovernmental hospitals are investor owned; the remaining 80 percent are not-for-profit. Furthermore, not-for-profit ownership is com- mon in the nursing home, home health care, and managed care industries.
Investor-Owned Corporations As discussed in the previous section, for-profit businesses can be organized in a variety of ways. However, because of their size, corporations are the largest employers of healthcare professionals. When the average person thinks of a corporation, she probably thinks of an investor-owned, or for-profit, cor- poration. Virtually all large businesses (e.g., Ford, Microsoft, IBM, General Electric) are investor-owned corporations.
Investors become owners of such businesses by buying shares of com- mon stock in the firm. Investors may buy common stock when it is first sold by the firm. Such sales are called primary market transactions. In a primary market transaction, the funds raised from the sale generally go to the cor- poration.5 After the shares have been initially sold by the corporation, they are traded in the secondary market. These sales may take place on exchanges, such as the New York Stock Exchange and the American Stock Exchange. They may also take place in the over-the-counter market, which is composed of a large number of dealers/brokers connected by a sophisticated electronic trading system. When shares are bought and sold in the secondary market, the corporations whose stocks are traded receive no funds from the trades; corporations receive funds only when shares are first sold to investors.
Investor-owned corporations may be publicly or privately held. The shares of publicly held firms are owned by a large number of investors and are widely traded. For example, Tenet Healthcare (www.tenethealth.com), which operates about 50 hospitals and has more than 480 million shares outstanding, is owned by approximately 50,000 individual and institutional stockholders. Drug manufacturers, such as Merck and Pfizer; medical equipment manufac- turers, such as St. Jude Medical, which makes heart valves; and U.S. Surgical, which makes surgical stapling instruments, are all publicly held corporations.
39Chapter 1 Supplement: Forms of Business Organization, Ownership, and Structure
Conversely, the shares of privately held, also called closely held, firms are owned by just a handful of investors or by a private business that owns other businesses and are not publicly traded. In general, the managers of privately held firms are major stockholders. In terms of ownership and con- trol, therefore, privately held firms are more similar to partnerships than to publicly held firms. Often, the privately held corporation is a transitional form of organization that exists for a short time before a proprietorship or partnership becomes a publicly owned corporation, motivated to go public by capital needs. Wellsprings Healthcare, a Texas firm that helps employers control healthcare costs, is an example of a closely held firm in the health ser- vices industry. Another example is HCR Manor Care (www.hcr-manorcare. com), which owns and operates more than 500 skilled nursing and rehabilita- tion centers and assisted living facilities and is owned by the Carlyle Group, a private investment firm.
Stockholders, also called shareholders, are the owners of investor-owned firms. As owners, they have three basic rights:
1. The right of control. Common stockholders have the right to vote for the corporation’s board of directors, which oversees the management of the firm. Each year, a firm’s stockholders receive a proxy ballot, which they use to vote for directors and vote on other issues proposed by management or stockholders. In this way, stockholders exercise control. In the voting process, stockholders cast one vote for each common share held.
2. A claim on the residual earnings of the firm. A corporation sells products or services and realizes revenues from the sales. To produce these revenues, the corporation must incur expenses for materials, labor, insurance, debt capital, and so on. Any excess of revenues over expenses—the residual earnings—belongs to the shareholders of the business. Often, a portion of these earnings are paid out in the form of dividends, which are cash payments to stockholders, or stock repurchases, in which the firm buys back shares held by stockholders. However, management typically elects to reinvest some or all of the residual earnings in the business, which presumably will produce even higher payouts to stockholders in the future.
3. A claim on liquidation proceeds. In the event of bankruptcy and liquidation, shareholders are entitled to any proceeds that remain after all other claimants have been satisfied.
In summary, there are three key features of investor-owned corpora- tions. First, the owners (the stockholders) of the business are well defined and exercise control of the firm by voting for directors. Second, the residual
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earnings of the business belong to the owners, so management is responsible only to the stockholders for the profitability of the firm. Third, investor- owned corporations are subject to taxation at the local, state, and federal levels.
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Not-for-Profit Corporations If an organization meets a set of stringent requirements, it can qualify for incorporation as a tax-exempt, or not-for-profit, corporation. Tax-exempt cor- porations are sometimes called nonprofit corporations. Because nonprofit busi- nesses (as opposed to pure charities) need profits to sustain operations, and because it is hard to explain why nonprofit corporations should earn profits, the term not-for-profit is more descriptive of nonprofit health services corporations.
Tax-exempt status is granted to businesses that meet the tax definition of a charitable corporation, as defined by Internal Revenue Service (IRS) Tax Code Section 501(c)(3) or (4). Hence, such corporations are also known as 501(c)(3) or (4) corporations. The tax code defines a charitable organization as “any corporation, community chest, fund, or foundation that is organized and operated exclusively for religious, charitable, scientific, public safety, liter- ary, or educational purposes.” Because the promotion of health is commonly considered a charitable activity, a corporation that provides healthcare ser- vices can qualify for tax-exempt status, provided it meets other requirements.6
In addition to having a charitable purpose, a not-for-profit corpora- tion must operate exclusively for the public, rather than private, interest. Thus, no profits can be used for private gain and no political activity can be conducted. Also, if the corporation is liquidated or sold to an investor-owned firm, the proceeds from the liquidation or sale must be used for a charitable purpose. Because individuals cannot benefit from the profits of not-for-profit corporations, such organizations cannot pay dividends. However, prohibition of private gain from profits does not prevent parties of not-for-profit corpo- rations, such as managers and physicians, from benefiting through salaries, perquisites, contracts, and so on.
Not-for-profit corporations differ significantly from investor-owned corporations. Because not-for-profit firms have no shareholders, no single body of individuals has ownership rights to the firm’s residual earnings or exercises control of the firm. Rather, control is exercised by a board of trustees, which is not constrained by outside oversight. Also, not-for-profit corporations are generally exempt from taxation, including both property and income taxes, and have the right to issue tax-exempt debt (municipal bonds). Finally, individual contributions to not-for-profit organizations can be deducted from taxable income by the donor, so not-for-profit firms have access to tax-subsidized contribution capital. (The tax benefits enjoyed by not-for-profit corporations are reviewed in the previous section on tax laws.)
Forms of Business Organization, Ownership, and Structure
The financial problems facing most federal, state, and local govern- ments have caused politicians to take a closer look at the tax subsidies provided to not-for-profit hospitals. For example, several bills have been introduced in Congress that require hospitals to provide minimum levels of care to the indigent to retain tax-exempt status. Such efforts by Congress prompted the American Hospital Association in 2007 to publish guidelines for charity care that include (1) giving discounts to uninsured patients of “limited means”; (2) establishing a common definition of “community ben- efits,” which encompass the full range of services provided to the popula- tion served; and (3) improving “transparency,” or the ability of outsiders to understand a business’s governance structure and policies, including execu- tive compensation. Starting with tax year 2009, Schedule H of the revised Form 990 requires that hospitals collect and analyze additional data regard- ing their community benefit activities and the charity care they provide, and determine the value of both according to standards adopted by the IRS.
Likewise, officials in several states have proposed legislation that man- dates the amount of charity care provided by not-for-profit hospitals and the billing and collections procedures applied to the uninsured. For example, Texas has established minimum requirements for charity care, which hold not-for-profit hospitals accountable to the public for the tax exemptions they receive. The Texas law specifies four tests, and each hospital must meet at least one of them. The test that most hospitals use to comply with the law requires that at least 4 percent of net patient service revenue be spent on charity care. Ohio legislators have held hearings to discuss whether a law should be passed requiring Ohio’s not-for-profit hospitals to make “Pay- ments in Lieu of Taxes” (PILOTs).
Finally, money-starved municipalities in several states have attacked the property tax exemption of not-for-profit hospitals that have “neglected” their charitable missions. For example, tax assessors are fighting to remove property tax exemptions from not-for-profit hospitals in several Pennsylva- nia cities after an appellate court ruling supported the Erie school district’s authority to tax a local hospital that had strayed too far from its charitable purpose. According to one estimate, if all not-for-profit hospitals had to pay taxes comparable to those their investor-owned counterparts pay, local, state, and federal governments would garner an additional $3.5 billion in tax revenues. This estimate explains why tax authorities in many jurisdictions are pursuing not-for-profit hospitals as a source of revenue.
The inherent differences between investor-owned and not-for-profit organizations have profound implications for many elements of healthcare financial management, including organizational goals, financing decisions (i.e., the choice between debt and equity financing and the types of securities issued), and capital investment decisions. Ownership’s effect on the
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application of healthcare financial management theory and concepts is addressed throughout the text.
SELF-TEST QUESTIONS 1. What are the major differences between investor-owned and not-
for-profit corporations? 2. What pressures have been placed on not-for-profit hospitals to
ensure that they meet their charitable mission?
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Organizational Structures
Whether investor owned or not-for-profit, health services organizations can be structured in an almost unlimited number of ways. At the most basic level, a healthcare provider can be a single entity with one operating unit. In this situation, all of the financial management decisions for the organization are made by a single set of managers. Alternatively, corporations can be set up with separate operating divisions or as holding companies with wholly or partially owned subsidiary corporations in which different management layers have different financial management responsibilities.
Holding Companies Today, many organizations—both investor owned and not-for-profit—have adopted holding company structures to take advantage of economies of scale, or scope, in operations and financing or to gain favorable legal or tax treat- ment. Holding companies date from 1889, when New Jersey became the first state to pass a law permitting corporations to be formed for the sole purpose of owning the stocks of other firms. Many of the advantages and disadvantages of holding companies are identical to those inherent in a large firm with several divisions. Whether a firm is organized on a divisional basis or as a holding company with several subsidiary corporations does not affect the basic reasons for conducting large-scale, multiproduct or multiservice, multifacility operations. However, the holding company structure has some distinct advantages and disadvantages when compared with the divisional structure.
There are several advantages to holding companies:
• Control with fractional ownership. A holding company may buy a fraction of the stock of another corporation, say 5, 10, or 50 percent. Such fractional ownership may be sufficient in giving the acquiring firm effective working control, or at least substantial influence, over the operations of the firm in which it has acquired stock ownership.
Working control is often considered to entail more than 25 percent of the common stock, but it can be as low as 10 percent if the stock is widely held. Isolation of risks. Because the various operating firms in a holding company system are separate legal entities, the obligations of one unit are separate from those of the other units. Therefore, catastrophic losses incurred by one unit of the system are not transferable into claims against the other units. This separation can be especially beneficial when the operating units carry the potential for large losses from malpractice or other liability lawsuits. Note, though, that the parent firm often voluntarily steps in to aid a subsidiary with large losses, either to protect the good name of the firm or to protect its investment in the subsidiary. Separation of for-profit and not-for-profit subsidiaries. Holding company organization facilitates expansion into both tax-exempt and taxable activities well beyond patient care. However, a tax-exempt holding company must ensure that all transactions with the taxable subsidiaries are conducted at arm’s length, otherwise the tax-exempt status of the parent holding company can be challenged. Investor- owned multihospital systems are organized similarly, except all of the entities are taxable, for-profit organizations. Note that although not- for-profit holding companies are allowed to have taxable subsidiaries, for-profit holding companies are not permitted to own tax-exempt subsidiaries.
Holding companies have the following disadvantages:
Partial multiple taxation. Investor-owned holding companies that own at least 80 percent of a subsidiary’s common stock can file a consolidated return for federal income tax purposes. In effect, the holding company and the subsidiary are treated as a single entity; all of their revenues and costs are aggregated. However, when less than 80 percent of the stock is owned, the only way that the subsidiary can transfer funds to the holding company is by paying dividends, and such dividends face partial multiple taxation. For example, holding companies that own more than 20 percent but less than 80 percent of the stock of another corporation must pay tax on 20 percent of the dividends received (80 percent are nontaxable), and companies that own less than 20 percent must pay tax on 30 percent of the dividends (70 percent are nontaxable). Because the subsidiary must pay taxes on the earnings prior to making the dividend payment, the funds transferred to the parent are taxed twice.
• Ease of forced divestiture. In the event of antitrust action, a holding company can easily reb squish ownership in a subsidiary by selling the stock to another party. This ease of transfer is considered a disadvantage because it increases the likelihood that government agencies will demand divestiture if antitrust concerns arise.
Multihospital Systems Multihospital systems, including tax-exempt and for-profit organizations, have grown much faster than freestanding hospitals over the past 30 years. Several advantages of multihospital systems have been hypothesized, including the following:
• Better access to capital markets, which results in lower capital costs • Elimination of duplicate services, which increases the volume of
services at the remaining sites and results in lower unit costs and increased quality
• Economies of scale • Access to specialized managerial skills within the system • Ability to recruit and retain better personnel because of superior
training programs, advancement opportunities, and transfer opportunities
• Increased political power in dealing with governmental issues such as property taxes, certificates of need, and government reimbursement systems
• Increased bargaining power with payers
In recent years, the largest systems have tended to shed some hospi- tals, although there continues to be some consolidation within local markets. Hospital systems appear to have more economies of scale within local markets than they do regionally or nationally. However, large healthcare systems have also faced increased scrutiny as critics question whether their group bargain- ing power stifles competition. For example, Partners HealthCare System, which includes two large academic medical centers and 11 community hospi- tals and outpatient facilities, was the subject of a spotlight series in the Boston Globe that accused the organization and its pricing strategies for the increase in the cost of care in Massachusetts.
Corporate Alliances Corporate alliances can provide some of the benefits of multi-institutional systems without requiring common ownership. Industry trade groups, which tend to operate at both state and national levels, are the least binding type of corporate alliance. For example, the American Hospital Association and
Chapter 1 Supplement: Forms of Business Organization, Ownership, and Structure 45
its state organizations—such as the Florida Hospital Association—consti- tute one major hospital trade association. Also, the American Association of Equipment Lessors is the trade group for firms that lease equipment to the health services industry.
Other types of alliances can be more binding but provide more ben- efits to their members. For example, several hospital alliances exist primarily to give their members purchasing clout. One of the largest of such alliances is VHA (formerly Voluntary Hospitals of America), a for-profit firm whose shareholders are its member hospitals, all not-for-profit institutions, and their physicians. VHA’s firms and subsidiaries provide members and affiliates with management services in such areas as procurement, data management, marketing, and even capital acquisition. VHA’s members and affiliates retain local control and autonomy yet gain many of the advantages of a large system.
In addition to alliances among similar organizations, alliances are also being formed among dissimilar providers to offer a more complete range of services. Such vertical alliances are discussed in the next section.
Integrated Delivery Systems The most dynamic recent changes to organizational structures in health ser- vices have centered on the integrated delivery system.' In the 1970s, horizon- tal integration, such as the combining of hospitals, was the dominant trend in organizational evolution. In the 1980s and well into the 1990s, the dominant organizational movement was toward vertically integrated systems. In an integrated delivery system, a single organization (or a closely aligned group of organizations), offers a broad range of patient care and support services operated in a unified manner. The range of services offered by an integrated delivery system may focus on a particular area, such as long-term care or mental health; more commonly, it may offer comprehensive subacute, acute, and postacute services.
An integrated delivery system may have a single owner, or it may have multiple owners joined together by contracts and agreements. The driving force behind these systems is the motivation to offer a full line of coordinated services and hence to increase the overall effectiveness and lower the overall cost of the services provided. Costs are reduced by providing only necessary services and ensuring that the services are provided at the most cost-effective clinical level. Integrated delivery systems may be formed by managed care plans or even directly by employers, but more often they are formed by pro- viders to facilitate contracting with plans or employers.
The key feature of integrated delivery systems is that, to be successful, the primary focus must be the clinical effectiveness and profitability of the
system as a whole, as opposed to each individual element. This emphasis requires a much higher level of administrative and clinical integration than is
seen in most organizations; more important, it requires that managers of the
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46 Understanding Healthcare Finance Management C
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system’s individual elements place their own interests second to those of the overall system. In addition, it requires a management information system that seamlessly passes managerial and patient data among all of the components of the integrated system. Although single-owner systems appear to have advantages over systems that are contractually created, such advantages, if they do exist, have proven to be difficult to realize in practice. The emphasis now appears to be on creating smaller, more focused businesses that are easier to manage. However, the integration of hospitals and physicians appears to be gaining momentum in response to healthcare reform and implementation measures that reward hospital-physician cooperation.
SELF-TEST QUESTIONS 1. What are the advantages and disadvantages of the holding
company form of organization? 2. What is the difference between horizontal and vertical
integration? 3. What are integrated delivery systems, how are they created,
and what is the driving force behind them? What challenges do integrated delivery systems face?
Supplement Key Concepts This chapter supplement presents some background information on forms of business organization and alternative forms of ownership. Here are its key concepts:
• The four forms of business organization are sole proprietorships partnerships corporations an^ hybrid.
• Although each form of organization has unique advantages and disadvantages, most large organizations and all not-for-profit entities are organized as corporations.
• Investor-owned corporations have shareholders who are the owners of the firm. Shareholders exercise control through the proxy process by electing the firm’s board of directors and voting on matters of major consequence to the firm. As owners, the shareholders have a claim on the residual earnings of the firm. Investor-owned firms are fully taxable.
• Organizations that serve a charitable purpose and meet certain criteria can be organized as not-for-profit corporations. Rather than have a well-defined set of owners, such organizations have a large
47
number of stakeholders who have an interest in the organization. Not-for-profit firms do not pay taxes, can accept tax-deductible contributions, and can issue tax-exempt (municipal) debt.
The various forms of business organization influence both health- care operations and financial management and have an impact on organi- zational goals. Chapter 1 discusses organizational goals and the implica- tions on for-profit and not-for-profit healthcare corporations.
Supplement Bibliography
Greener, B. 2007. “Finding the Right Structure for Your Business.” Optics and Pho- tonics News 18 (5): 12.
Schneeman, A. 1997. The Law of Corporations, Partnerships, and Sole Proprietorships. Albany, NY: Delmar Publishers.
Supplement Websites
The following websites pertain to the content of this chapter:
• For more information on forms of business organization, go to http:// bls. dor. wa. gov/index, aspx.
• For information on the various forms of corporations, go to www.sos. wa.gov/corps/.
Supplement Notes
1. Note that a tax-exempt corporation can be one partner of a partnership. In this situation, profits allocated to the tax-exempt partner are not taxed, but those allocated to taxable partners are subject to taxation.
2. Although most partnerships are small, some large firms are organized as partnerships or as hybrid organizations. Examples include major public accounting firms and many large law firms.
3. Financial markets bring together individuals and businesses that need money with other individuals and businesses that have excess funds to invest. In a developed economy, such as in the United States, there are many financial markets. Some markets deal with debt capital, while
48 Understanding Healthcare Finance Management C
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others deal with equity capital; some deal with short-term capital, and others deal with long-term capital; and so on. The ways in which financial markets operate and their benefits to healthcare businesses are discussed throughout the text.
4. More than 60 percent of corporations in the United States are chartered in Delaware, which over the years has provided a favorable governmental and legal environment for business activities. A firm does not have to be headquartered or even conduct business in its state of incorporation.
5. In rare situations, shares can be sold to the public for the first time by the corporation’s original owners or by a foundation established by the owners, rather than directly by the firm. In such situations, the proceeds from the sale go to the original owners or foundation and not to the firm. Stock sales are discussed in more detail in Chapter 7.
6. An entire chapter can easily be filled with the details of obtaining and maintaining tax-exempt status, but our focus is on the impact of such status on financial management decision making.
7. For a thorough discussion of integrated delivery systems, see Lega, F. 2007. “Organizational Design for Health Integrated Delivery Systems: Theory and Practice.” Health Policy 81 (2-3): 258-79.
LnAricix
HEALTH INSURANCE 2 Learning Objectives After studying this chapter, readers should be able to
• describe the key features of insurance, • describe the major private and public insurers, • demonstrate how insurers set premium rates for buyers, and • assess the implications of health reform for the health insurance
industry.
Introduction
In general, businesses in the healthcare sector that do not provide products or services directly to patients have the same operating environment as busi- nesses in any other industry. For example, Cincinnati Milicron, a machine tool manufacturer, and GE Medical Systems sell their products in roughly the same way. Cincinnati Milicron sells its machines directly to manufactur- ers that use the machines to produce other goods, and GE Medical sells its diagnostic equipment directly to hospitals, medical practices, and other orga- nizations that use the equipment for diagnostic testing. The prices that the two firms charge for their products are set in the competitive marketplace, and it is relatively easy for buyers to distinguish among competing products. In general, the more expensive the product is, the better the performance, where performance can be judged on the basis of objective measures. Thus, in some industries in the healthcare sector, and in most other sectors of the economy, the consumer of the product or service (1) has a choice among many suppliers, (2) can distinguish the quality of competing goods or ser- vices, (3) makes a (presumably) rational decision regarding the purchase on the basis of quality and price, and (4) pays the full cost of the purchase.
For the most part, the provision of healthcare services takes place in a unique way. First, often only a few providers of a particular service exist in a given area. Next, it is difficult, if not impossible, to judge the quality of competing services. Then, the decision about which services to purchase is usually not made by the consumer but by a physician or some other cli- nician. Also, payment to the provider is not normally made by the user of
49
50 Understanding Healthcare Finance Management
the services but by a third-party payer. Finally, for most individuals, health insurance from third-party payers is totally paid for or heavily subsidized by employers or government agencies, so patients are mosdy insulated from the costs of healthcare.
This highly unusual marketplace for healthcare services has a profound effect on the supply of, and demand for, such services. In this chapter, we discuss elements of health insurance that directly affect financial management decisions in health services organizations.
Insurance Concepts
The third-party payer system is an insurance system comprising a wide variety of insurers of all types and sizes. Some are investor-owned, while others are not-for-profit or government-sponsored. Some insurers require their policy- holders, who may or may not be the beneficiaries of the insurance, to make the policy payments, while other insurers collect partial or total payments from society at large. Because insurance is the cornerstone of the third-party payer system, an appreciation of the nature of insurance will help you better understand the marketplace for healthcare services.1
A Simple Illustration To better understand insurance concepts, consider a simple example. Assume that no health insurance exists and you face only two medical outcomes in the coming year:
Outcome
Stay healthy Get sick
Probability Cost
0.99 0.01 1.00
$ 0 20,000
Furthermore, assume that everyone else faces the same medical out- comes and “sees” the same odds and costs associated with healthcare. What is your expected healthcare cost—E(Cost)—for the coming year? To find the answer, we multiply the cost of each outcome by its probability of occurrence and then sum the products:
E(Cost) = (Probability of outcome 1 x Cost of outcome 1)
+ (Probability of outcome 2 x Cost of outcome 2)
= (0.99 x $0) + (0.01 x $20,000)
= $0 + $200 = $200.
Now, assume that you, and everyone else, make $20,000 a year. With this salary, you can easily afford the $200 “expected” healthcare cost. The problem is, however, that no one’s actual bill will be $200. If you stay healthy, your bill will be zero, but if you are unlucky and get sick, your bill will be $20,000. This cost will force you, and most people who get sick, into personal bankruptcy.
Now, suppose an insurance policy that pays all of your healthcare costs for the coming year is available for $250. Would you purchase the policy, even though it costs $50 more than your expected healthcare costs? Most people would. In general, individuals are risk averse, so they would be will- ing to pay a $50 premium over their expected costs to eliminate the risk of financial ruin. In effect, policyholders are passing to the insurer the costs associated with the risk of getting sick.
Would an insurer be willing to offer the policy for $250? If the insurer can sell enough policies, it can take advantage of the law of large numbers. We know that it is impossible to predict the healthcare costs for the coming year for any one individual with any certainty because the cost will be either $0 or $20,000, and we will not know for sure until the year is over. For any indi- vidual, the expected cost of healthcare is $200, but the standard deviation is a whopping $1,990, so there is significant uncertainty about each individual’s required expenditure.
However, if an insurance company sells a million policies, its expected total policy payout is one million times the expected payout for each policy, or 1 million x $200 = $200 million. Furthermore, the law of large numbers tells us that the standard deviation of costs to an insurer with a large number of policyholders is c/fn, where c> is the standard deviation for one individual and n is the number of individuals insured. Thus, payout uncertainty for the insurer, as measured by standard deviation, is only $1,990/^/1,000,000 = $1.99 per subscriber, or $1.99 million in total. Given these data, we see that if there were no uncertainty about the $20,000 estimated medical cost per claim, the insurer could forecast its total claims precisely. It would col- lect 1 million x $250 = $250 million in health insurance premiums; pay out roughly $200 million in claims; and hence have about $50 million to cover administrative costs, create a reserve in case realized claims are greater than predicted by its actuaries, and make a profit. Clearly, with a standard devia- tion of claims of about $2 million, the $50 million “cushion” should be suf- ficient to carry out a successful business. The problem for real-world insurers is their inability to forecast the cost of each claim.
Basic Characteristics of Insurance The simple example of health insurance we just provided illustrates why indi- viduals would seek health insurance and why insurance companies would be
52 Understanding Healthcare Finance Management
formed to provide such insurance. Needless to say, the concept of insurance becomes much more complicated in the real world. Insurance is typically defined as having four distinct characteristics:
1. Pooling of losses. The pooling, or sharing, of losses is the heart of insurance. Pooling means that losses are spread over a large group of individuals so that each individual realizes the average loss of the pool (plus administrative expenses) rather than the actual loss incurred. In addition, pooling involves the grouping of a large number of homogeneous exposure units (people or things having the same risk characteristics) so that the law of large numbers can apply. Thus, pooling implies (1) the sharing of losses by the entire group and (2) the prediction of future losses with some accuracy, based on the law of large numbers.
2. Payment only for random losses. A random loss is one that is unforeseen and unexpected and occurs as a result of chance. Insurance is based on the premise that payments are made only for losses that are random. We discuss the moral hazard problem, which concerns losses that are not random, in a later section.
3. Risk transfer. An insurance plan almost always involves risk transfer. The sole exception to the element of risk transfer is self-insurance, which is assumption of a risk by a business (or individual) itself rather than by an insurance company. (Self-insurance is discussed in a later section.) Risk transfer is transfer of a risk from an insured to an insurer, which typically is in a better financial position to bear the risk than the insured because of the law of large numbers.
4. Indemnification. The final characteristic of insurance is indemnification for losses—that is, the reimbursement of the insured if a loss occurs. In the context of health insurance, indemnification occurs when the insurer pays the insured, or the provider, in whole or in part for the expenses related to an insured illness or injury.
Adverse Selection One of the major problems facing insurers is adverse selection. Adverse selec- tion occurs because individuals and businesses that are more likely to have claims are more inclined to purchase insurance than those that are less likely to have claims. For example, an individual without insurance who needs a costly surgical procedure will likely seek health insurance if she can afford it, whereas an individual who does not need surgery is much less likely to purchase insurance. Similarly, consider the likelihood of a 20-year-old to seek health insurance versus the likelihood of a 60-year-old. The older individual, with much greater health risk due to age, is more likely to seek insurance.
Chapter 2: Health Insurance 53r If this tendency toward adverse selection goes unchecked, a dispropor-
tionate number of sick people, or those most likely to become sick, will seek health insurance, and the insurer will experience higher-than-expected claims. This increase in claims will trigger a premium increase, which only worsens the problem, because the healthier members of the plan will seek insurance from other firms at a lower cost or may totally forgo insurance. The adverse- selection problem exists because of asymmetric information, which occurs when individual buyers of health insurance know more about their health status than do insurers.
Insurance companies attempt to control the adverse selection problem by underwriting provisions. Underwriting refers to the selection and clas- sification of candidates for insurance. From a health insurance perspective, insurers can take two extreme positions regarding underwriting. First, if we assume that insurers offer insurance in all 50 states, insurers can base premi- ums on national average statistics without regard to individual characteristics. Thus, each individual (or employer) would pay the same health insurance premium regardless of age, gender, geographic location, line of work, smok- ing habits, genetic disposition, and so on. The premium charged for each individual would be sufficient in the aggregate to cover all expected outlays, plus administrative expenses, and the insurer would still earn a profit. In this situation, cross-subsidies clearly exist because young, healthy nonsmokers in relatively safe jobs would pay the same premiums as older, sickly smokers in relatively hazardous jobs. Thus, after taking administrative costs out of the insurance premium, healthy individuals would pay premiums that exceed their expected healthcare costs, while the sicker individuals would pay premi- ums that are lower than their expected costs.
At the other extreme, if no information asymmetries existed and per- fect information were available, insurers could charge a premium to each subscriber on the basis of that subscriber’s expected healthcare costs, as was done in the illustration presented previously. Individuals who are expected to have higher costs would be charged higher premiums, and those with lower expected costs would be charged lower premiums. Of course, neither indi- viduals nor insurers have perfect foresight, so charging an insured individual on the basis of his expected healthcare costs is not feasible. However, insurers can take into account all factors that are proven to affect health status (and hence costs)—such as smoking habits, weight, cholesterol level, and heredi- tary factors—when setting insurance rates.
What approach do health insurers take in practice? When health insurance first became popular following World War II, most insurers used community ratings. They offered a single set of premiums, or rates, to all members of a community without regard to age, gender, health status, and so on. The rates represented an average of high-risk and low-risk individuals in
54 Understanding Healthcare Finance Management
that community. Thus, rates reflected geographic differences and sometimes ethnic and cultural differences if the community was dominated by a single ethnic or cultural group. Over time, some insurers (particularly commercial insurers) started to offer experience ratings—meaning they set rates on the basis of the claims experience of the group being insured.
For example, the Boeing Company might contract with a health insurer to insure all of Boeing’s employees in the Seattle area. If Boeing’s employees—who as a group tend to be younger and more educated—have lower healthcare costs than the community in general, insurers that use experience ratings can offer Boeing lower rates than those offered by com- petitors that use community ratings. As more and more employers with low- risk employees seek health insurance based on experience ratings, the least costly groups are skimmed from the insurance pool, and those that remain are charged higher-than-average costs. Because the healthcare costs for those remaining are above the community average, insurers serving that population have no choice but to apply experience ratings, so higher premiums will be charged to the remaining groups. The trend over time, then, has been toward the use of experience ratings and away from the use of community ratings, although community ratings are still used.
Another way health insurers used to protect themselves against adverse selection was by including preexisting conditions clauses in contracts. A pre- existing condition is a physical or mental condition of the insured individual that existed before the policy was issued. A typical clause stated that preex- isting conditions were not covered until the policy had been in force for a certain period—say, one or two years. Preexisting conditions were a problem for the health insurance industry. As we discussed earlier, one of the key elements of insurance is randomness—that is, payouts on a policy should be made in response to random events. If an individual had a preexisting condition, this key feature of insurance was violated, as the insurer no longer bore random risk but rather assumed the role of payer for the treatment of a known condition.
Actions taken by insurers that are considered to be unfair to policy- holders (including preexisting condition clauses) have been the subject of much recent congressional legislation. First, Congress passed the Health Insurance Portability and Accountability Act (HIPAA) in 1996. Among other things, HIPAA established national standards regarding what provi- sions can be included in health insurance policies. For example, under a group health policy, individuals cannot be denied coverage or receive limited coverage, nor can they be required to pay more because of their health status. Although preexisting condition clauses were not banned by HIPAA, it estab- lished limits as to what counts as a preexisting condition and to the amount of time that must pass before coverage begins. Many of the provisions of
Chapter 2: Health Insurance 55
HIPAA are strengthened by the Patient Protection and Affordable Care t ( ^CA) of 2010, which now prohibits insurers from denying coverage because of a preexisting condition. The ACA, along with the Health Care and Education Reconciliation Act of 2010, included a large number of provi- sions that have (save for a few) taken effect over the past several years to help uninsured Americans obtain health insurance, improve healthcare quality and access and reduce costs. These changes are described in the last section of this chapter.
Moral Hazard Insurance is based on the premise that payments are made only for random
losses, and from this premise stems the problem of moral hazard. The most common case of moral hazard in a casualty insurance setting is the owner who deliberately sets a failing business on fire to collect the insurance. Moral hazard is also present in health insurance, but it typically takes a less dra- matic form; few people are willing to voluntarily sustain injury or illness for die purpose of collecting health insurance. However, undoubtedly there are people who purposely use healthcare services that are not medically required. For example, some people might visit a physician or a walk-in clinic for the social value of human companionship rather than to address a medical neces- sity. Also, some hospital discharges might be delayed for the convenience of the patient rather than for medical purposes. Finally, when insurance covers the foil cost or most of the cost of healthcare services, individuals often are quick to agree to a $1,000 MRI (magnetic resonance imaging) scan or other high-cost procedure that may not be necessary. If the same test required total out-of-pocket payment, individuals would think twice before agreeing to such an expensive procedure unless they clearly understood the medical necessity involved. All in all, when somebody else is paying the costs, patients consume more healthcare services.
Even more insidious is the impact of insurance on individual behav- ior. Individuals are more likely to forgo preventive actions and embrace unhealthy behaviors when the costs of not taking those actions will be borne by insurers. Why stop smoking if the monetary costs associated with cancer treatment are borne by the insurer, or why lose weight if others will pay for the adverse health consequences likely to result?
Insurers generally attempt to protect themselves from moral hazard claims by paying less than the foil amount of healthcare costs borne by the insured. By making insured individuals bear some of the cost, insurers dis- courage them from consuming unneeded services or engaging in unhealthy behaviors. One way of doing this is to require a deductible. Medical policies usually contain some dollar amount that must be satisfied before benefits are paid. Although deductibles have a positive effect on the moral hazard
56 Understanding Healthcare Finance Management
problem, their primary purpose is to eliminate the payment of small claims because the administrative cost of processing the claim may be larger than the claim itself. Although several types of deductibles exist, the most common form is the calendar-year deductible. Here, the insured individual pays the first $250 (or $500 or more) of medical expenses she incurs each year. Once the deductible is met, the insurer pays all eligible medical expenses (less any copayments) for the remainder of the year.
The primary weapon that insurers have against the moral hazard problem is the copayment, which requires insured individuals to pay a cer- tain percentage of eligible medical expenses—say, 20 percent—in excess of the deductible amount. For example, assume that George Maynard, who has employer-provided medical insurance that pays 80 percent of eligible expenses after the $100 deductible is satisfied, incurs $10,000 in medical expenses during the year. The insurer will pay 0.80 x ($10,000 - $100) = 0.80 x $9,900 = $7,920, so George’s responsibility is $10,000 - $7,920 = $2,080.
The purposes of copayments are to reduce premiums to employers and to prevent overutilization of healthcare services. Because insured individuals pay part of the cost, premiums can be reduced. Additionally, by being forced to pay some of the costs, insured individuals will presumably seek fewer and more cost-effective treatments and embrace a healthier lifestyle.
Some health insurance policies contain stop-loss limits, also called out- of-pocket maximums. After the insured individual pays a certain amount of copayment costs—say, $2,000—the insurer pays all covered costs, including copayments. Thus, if George had $50,000 of covered expenses above the deductible amount, his coinsurance share would be $10,000 if there were no stop-loss provision. If his policy contained a stop-loss amount of $2,000, George would only have to pay $2,000 and his insurer would pay the remain- ing $48,000 of costs. Of course, health insurance policies with stop-loss provisions are more cosdy than those without such features.
SELF-TEST QUESTIONS 1. Briefly explain the following characteristics of insurance:
a. Pooling of losses b. Payment only for random losses c. Risk transfer d. Indemnification
2. What is adverse selection, and how do insurers deal with the problem?
3. What is the moral hazard problem?
Chapter 2: Health Insurance 57
Major Health Insurers (Third-Party Payers)
Up to this point, we have discussed basic concepts of insurance, some key elements of health insurance, and general types of reimbursement method- ologies. Now we provide a brief background of the major health insurers (third-party payers) and, more important, discuss some of the specific reim- bursement methods they use to pay healthcare providers.
Health insurance originated in Europe in the early 1800s, when mutual benefit societies were formed to reduce the financial burden associ- ated with illness or injury. Today, health insurers can be divided into two broad categories: (1) private insurers and (2) public programs.
1. What are the two major classifications of health insurers? SELF-TEST QUESTION
Private Insurers
In the United States, the concept of public, or government, health insurance is relatively new, while private health insurance has been in existence since the turn of the twentieth century. In this section, we discuss the major private insurers—Blue Cross and Blue Shield, commercial insurers, and self-insurers.
Blue Cross and Blue Shield Blue Cross and Blue Shield organizations trace their roots to the Great
Depression, when hospitals and physicians were concerned about their patients’ ability to pay healthcare bills.
Blue Cross originated as a group of separate insurance programs offered by individual hospitals. At the time, many patients were unable to pay their hospital bills, but most individuals, except the poorest, could afford to purchase some type of hospitalization insurance. Thus, the programs were initially designed to benefit hospitals as well as patients. The programs were similar in structure. Hospitals agreed to provide a certain amount of services to program members who made periodic payments of fixed amounts to the hospitals whether services were used or not. In a short time, these programs were expanded from single hospital programs to communitywide multihos- pital plans called hospital service plans. The American Hospital Association (AHA) recognized the benefits of these plans to hospitals, so AHA and the organizations that offered hospital service plans formed close relationships.
In the early years, several states ruled that the sale of hospital services by prepayment did not constitute insurance, so the plans were exempt from regulations that govern the insurance industry. However, it was clear that the
58 Understanding Healthcare Finance Management
legal status of hospital service plans would be subject to scrutiny unless their status was formalized, so one by one the states passed enabling legislation that provided for the founding of not-for-profit hospital service corporations that were exempt from taxes and from the capital requirements mandated for other insurers. However, state insurance departments had, and continue to have, oversight over most aspects of the plans’ operations. The Blue Cross name was officially adopted by most of these plans in 1939.
Blue Shield plans developed in a manner similar to that of the Blue Cross plans, except that the providers were physicians instead of hospitals and the professional organization was the American Medical Association (AMA) instead of the AHA. As of 2014, there were 39 Blue Cross and Blue Shield member organizations; some offer only one of the two plans, but most offer both plans. Member organizations are independent corporations that operate locally or statewide under license from a single national association that sets standards that must be met to use the Blue Cross and Blue Shield name. Col- lectively, the “Blues” provide healthcare coverage for more than 100 million people in all 50 states, the District of Columbia, and Puerto Rico.
Historically, the individual state and local organizations have been not- for-profit corporations that enjoyed the full benefits accorded to that status, including freedom from taxes. In 1986, Congress eliminated the Blues’ tax exemption on the grounds that they operated “commercial-type” insurance activities. However, the plans were given special deductions, so their taxes are generally lower than those paid by commercial insurance companies. Despite the change in tax status, the national association continued to require all Blues to operate as not-for-profit corporations, although they could establish for-profit subsidiaries. In 1994, however, the national association lifted its ban on member plans becoming investor-owned companies.
Since 1994, several Blues companies have converted to for-profit sta- tus, including WellPoint Health Networks, which runs Blue Cross of Califor- nia. Although the number of for-profit companies is small, they enroll about one-quarter of all Blue Cross patients. Because state laws require the assets of not-for-profit corporations to be used for charitable purposes in perpetu- ity, conversion of ownership is a relatively complex endeavor. (We discuss the issues involved in conversion in Chapter 16.) To meet this requirement, plans that convert typically set up a charitable foundation to which they contribute a sum that is, in theory, equal to the value of the assets being converted. However, critics of conversions claim that the amounts contributed fall far short of the actual value of the tax exemptions that the not-for-profits receive during their existence.
Despite the conversions thus far, it is unlikely that many more Blues will convert to for-profit status because of the legal problems inherent in conversion and because they already have the ability to create for-profit
Chapter 2: Health Insurance 59
The main rationale for converting or creating for-profit subsid- iaries is to gain access to investor-supplied equity capital, which many believe is necessary for insurers to be competitive in today’s healthcare market.
Because the Blue Cross and Blue Shield corporations operate indepen- dently, they do not all use the same reimbursement method. However, over rhe past few years, the tendency has been to move away from cost-based and charge-based methods and toward prospective payment systems. For exam- ple some of the Blues use hospital reimbursement methods that are similar to Medicare’s prospective payment system based on diagnosis-related groups, while other Blues use a two-tier system that pays a per diem rate for routine hospitalizations and negotiated charge-based rates for nonroutine services.
Virtually all of the Blues now offer managed care plans along with more traditional indemnity insurance, and many plans are contracting exclu- sively with integrated delivery systems in certain service areas. In these situa- tions, capitation often is the method of payment to providers.
Commercial Insurance Commercial health insurance is issued by life insurance companies, by casualty
insurance companies, and by businesses formed exclusively to write health insurance. Commercial insurance companies can be organized either as stock or mutual businesses. Stock businesses are shareholder owned and can raise equity capital just like any other for-profit business can. Furthermore, the stockholders assume the risks and responsibilities of ownership and manage- ment. Mutual businesses have no shareholders; their management is controlled by a board of directors elected by the firm’s policyholders. Regardless of the form of ownership, commercial insurance businesses are taxable entities.
Health insurance experienced an influx of commercial insurers fol- lowing World War II. At that time, the United Auto Workers negotiated the first contract with employers, of which fringe benefits for employees were a major part. The majority of individuals with commercial health insurance are covered under group policies with employers, professional and other associa- tions, or labor unions. Group health coverage has the following advantages over individual coverage:
• Group coverage has low administrative costs because many individuals are insured under a single contract. This type of coverage lowers the costs associated with sales and administration of the contract. The group contract holder—for example, the employer or labor union— usually subsidizes the premium in part or in full. Note, though, that employers that have costly employee health programs are usually forced by competitive pressures to offset higher healthcare costs with lower wages or reductions in other fringe benefits. Also, the competitive
6o Understanding Healthcare Finance Management
labor market forces employers to offer competitive aggregate benefits, although the benefit mix may differ.
• Generally, eligibility for a group plan does not depend on the insured individual’s health status. The insurer bases its premiums on the overall health status of the group. Note, however, that the premiums paid by groups that have a small number of members can be adversely affected by the poor health of one individual.
• In general, an individual’s coverage cannot be canceled unless the individual leaves the group or the plan is terminated.
Traditionally, commercial insurers have reimbursed healthcare pro- viders on the basis of billed charges. However, with the dramatic increase in healthcare costs that has occurred over the past 20 years, the traditional providers of health insurance—employers and unions—have seen their healthcare premiums skyrocket. Clearly, this trend cannot continue, so the major purchasers of group health insurance have put pressure on the insur- ance companies to trim costs. This pressure, in turn, has forced commercial insurers to offer other reimbursement methods and delivery systems, includ- ing managed care plans, that give them a better chance of controlling costs than reimbursement on the basis of billed charges allows.
Self-Insurance The third major form of private insurance is self-insurance. One might think that all individuals who do not have any other form of healdi insurance are self-insurers, but this is not technically correct. Self-insurers make a conscious decision to bear the risks associated with healthcare costs and then set aside (or have available) funds to pay costs as they occur. Except for the wealthy, indi- viduals are not good candidates for self-insurance because they face too much uncertainty concerning future healthcare expenses. On the other hand, large groups, especially employers, are good candidates for self-insurance. Indeed, most large groups today are self-insured. For example, employees of the state of Florida are covered by health insurance administered by Blue Cross and Blue Shield of Florida, but the actual benefits to plan members are paid by the state. Blue Cross and Blue Shield is paid for administering the plan, but the state bears all risks associated with utilization and cost uncertainty.
Many firms today are going one step further in their self-insurance programs and bypassing third-party payers. For example, Digital Equipment Corporation (now owned by Hewlett-Packard), a major computer manufac- turer, negotiates discounts directly with hospitals and physicians. Others, such as Deere & Company, a farm implements manufacturer, have set up health services subsidiaries to provide healthcare services to their employees. For the most part, these firms use the same techniques that managed care
Chapter 2: Health Insurance 61
organizations use, but they try to do things better and at lower cost by apply- ■ kind of management attention to healthcare that they apply to their core businesses.
1. Briefly describe some different types of private insurers. SELF-TEST QUESTION
Public Insurers
The government is a major insurer and direct provider of healthcare services, for example, the government provides healthcare services directly to eligible individuals through the US Department of Veterans Affairs, Department of Defense, and Public Health Service medical facilities. In addition, the gov- ernment either provides or mandates a variety of insurance programs, such as workers compensation and TRICARE. In this section, we focus on the two major government insurance programs: Medicare and Medicaid.
Medicare Medicare was established by Congress in 1965 primarily to provide medical benefits to individuals aged 65 or older. About 50 million people have Medi- care coverage, which pays for about 17 percent of all US healthcare services.
Over the decades, Medicare has evolved to include four major cover- ages: (1) Part A, which provides hospital and some skilled nursing home coverage; (2) Part B, which covers physician services, ambulatory surgical services, outpatient services, and other miscellaneous services; (3) Part C, which is managed care coverage that can be selected in lieu of Parts A and B; and (4) Part D, which covers prescription drugs. In addition, Medicare covers healthcare costs associated with selected disabilities and illnesses (such as kidney failure), regardless of age.
Part A coverage is free to all individuals eligible for Social Security benefits. Elderly individuals who are not eligible for Social Security benefits can obtain Part A medical benefits by paying premiums of $426 per month (for 2014). Part B is optional to individuals who have Part A coverage. Most enrollees must pay a monthly premium of between $104.90 and $335.70 (for 2014), depending on income. About 97 percent of Part A participants purchase Part B coverage. Because of deductibles, copayments, coinsur- ance, and coverage limits, Medicare Parts A and B coverage can still require beneficiaries to bear significant out-of-pocket costs. Thus, many Medicare participants purchase additional coverage from private insurers to help cover the “gaps” in Medicare coverage. Such coverage is called Medigap insurance.
Part C coverage is an alternative to coverage under Parts A and B. It is offered by private insurance companies but paid for by Medicare. These
62 Understanding Healthcare Finance Management
plans, called Medicare Advantage plans, generally provide Parts A and g coverage along with many of the same benefits that a Medigap policy would include, so additional insurance is not required. (Some plans also include prescription drug [Part D] coverage.) However, because the plans are essen- tially managed care plans (which we discuss shortly), they typically have more restrictions on access than does standard coverage under Parts A and B. Also some Medicare Advantage plans charge members a small premium above the amount paid by Medicare.
Part D, which was implemented in 2006, offers prescription drug cov- erage through plans offered by more than 70 private companies. Each plan may offer somewhat different coverage, so the benefits and costs of Part D coverage vary widely, depending on the plan.
The Medicare program is the purview of the US Department of Health and Human Services (HHS), which creates the specific rules of the program on the basis of federal legislation. Medicare is administered by an agency in HHS called the Centers for Medicare & Medicaid Services (CMS). CMS has regional offices that oversee the Medicare program and ensure that regulations are followed. Medicare payments to providers are not made directly by CMS but by contractors for 15 Medicare Administrative Contrac- tor (or MAC) jurisdictions.
The Medicare Payment Advisory Commission (MedPAC) is an inde- pendent organization that advises Congress on issues affecting Medicare. MedPAC’s primary work is to prepare two reports annually—(1) one that focuses on payment policies, including specific reimbursement amounts, and (2) one that addresses other issues. Because MedPAC is the principal “inde- pendent” advisor to Congress on Medicare payment issues, its influence over the program is significant.
Medicaid Medicaid was established in 1966 as a modest program to be jointly funded and run by the states and the federal government to provide a medical safety net for low-income mothers and children and for elderly, blind, and disabled indi- viduals who receive benefits from the Supplemental Security Income program. Congress mandated that Medicaid cover hospital and physician care, but states were encouraged to expand on the basic package of benefits by either increasing the range of benefits or extending the program to the near poor (i.e., people who are not destitute but whose earnings cover only basic daily needs) through optional eligibility. A mandatory nursing home benefit was added in 1972.
States with large tax bases were quick to expand coverage to many of the optional groups, while states with limited ability to raise funds for Medic- aid were forced to construct limited programs. In 2012, Medicaid spending, including federal and state expenditures, totaled $431 billion. The federal
Chapter 2: Health Insurance 63
government picks up about 64 percent of these expenditures and the states pay for the remainder.
Because Medicaid is administered by the states, each state establishes its own reimbursement system. Although Medicaid has historically reim- bursed providers on a cost basis, more and more states are shifting to reim- bursement based on per diem and fixed-fee prospective rates similar to those instituted by Medicare. As Medicaid expenditures continue to rise at alarm- ing rates, policymakers are struggling to find cost-effective ways to reduce costs, maintain access, improve quality, and modify reimbursement systems.
Hospitals recently have been vocal in their claims that Medicaid reim- bursement does not cover the costs of service, and some have even sued their state governments for increased payments on the grounds that Medicaid laws call for “fair market” rate reimbursement. Physicians have also fared badly under Medicaid because states have tried to cut Medicaid costs by freezing physicians’ fees. Citing excess paperwork, high risks, and low fees, many phy- sicians—particularly obstetricians and pediatricians—have either stopped tak- ing Medicaid patients or are limiting the numbers they serve.
1. Briefly describe the origins and purpose of Medicare. 2. What is Medicaid, and how is it administered?
SELF-TEST QUESTIONS
Development of Premium Rates
One of the primary financial management functions of health insurance companies is the development of premium rates for healthcare buyers, typi- cally employers. This process involves estimating the total costs of providing healthcare services to the covered population. In this section, we discuss sev- eral methodologies for estimating provider payments, which are aggregated to estimate total costs, the basis for the premium rate. Although premium rates typically are developed by health insurers, some integrated health systems contract with insurers to provide all covered services at a fixed per-member rate. In these situations, the health system acts as an insurer because it assumes utilization risk. Thus, the material in this section is relevant to those circumstances. Finally, it is useful for managers at all healthcare providers to understand how health insurers set premiums because the premiums col- lected by insurers establish the dollars available to pay for provider services.
Allocating Premium Dollars Insurers collect premium dollars from employers and other purchasers of healthcare and then use those dollars to pay providers, cover administrative
Understanding Healthcare Finance Management
expenses, and earn profits. To better understand how insurers set their pre- mium rates, consider Exhibit 2.1, which is a sample illustration of how a health maintenance organization (HMO) spends a typical premium dollar.
First, HMOs have the same types of management and marketing expenses as any other business, so the premium dollar must cover such costs. Also, HMOs must earn profits, both to create reserves for contingencies and for distribution to stockholders (if the HMO is investor owned). About 16 percent of the premium dollar goes toward the HMO’s administrative costs and profit, and the remaining 84 percent is paid out to providers. The larg- est payout is typically for physician services—at 36 percent of the premium dollar. Of this amount, approximately 11 percent is spent on primary care, 16 percent on specialist care, 5 percent on ancillary services, and 4 percent on administration and profit of the physician group. (Often, physician ser- vices are contracted through a large medical group practice, which itself has administration costs and profit requirements.)
The next major item is payments for hospital and other institutional care provided within the HMO’s network (the HMO’s provider panel), which totals 33 percent of the premium dollar. In addition to medical ser- vices, patients are consuming a larger and larger amount of prescription drugs, which amount to about 10 percent of the premium dollar. Finally, HMO members sometimes require services from providers that are out of the HMO’s network, either because there are no in-network providers for that service or the services are required outside the geographic area served by
EXHIBIT 2.1
Sample Allocation of
the HMO Premium
Dollar
Total premium dollar ioo%
HMO administration/profit 16%
Paid to within-system physicians: Primary care n% Specialists 16 Ancillary services 5 Administration/profit 4
Total to within-system physicians 36%
Paid to within-system hospitals/institutions 33%
Paid for prescription drugs 10%
Paid to out-of-system providers 5%
Chapter 2: Health Insurance 65
the HMO. Payments to out-of-network providers, including physicians and hospitals/institutions, average 5 percent of the premium dollar.
Note that the percentages in Exhibit 2.1 are averages, and there are wide variations among HMOs as to how they allocate their premium dollars. Healthcare purchasers want a high percentage of the premium dollar to go to providers to encourage them to provide needed services in a timely manner. Conversely, HMOs have an incentive to lower the amount paid to providers, both to increase reserves and profits and to ensure competitive pricing for buyers in an increasingly hostile marketplace. Finally, note that healthcare reform legislation places restrictions on the proportion of premiums spent on administration. The purpose of such restrictions is to ensure that pre- mium dollars go to healthcare services rather than to bloated administrative expenses and profits.
Developing Premium Rates: An Illustration In this section, we illustrate several methods that an HMO or integrated delivery system can use to estimate the payments it must make to its provid- ers to provide services to a defined population.2 Rates are developed as if all providers were capitated because, at least initially, the premium rate will be calculated on a per member per month (PMPM) basis. When the rate is quoted to purchasers of health insurance, it may be quoted on a PMPM basis or some other basis, such as per individual or per family. Note, however, that providers can be reimbursed through capitation, discounted fee-for-service, or any other method.
Assume that BetterCare, Inc., must develop a premium bid to submit to Big Business, a major employer in BetterCare’s service area. For purposes of simplicity, assume that all medically necessary in-area services can be pro- vided by a single hospital that offers both inpatient and outpatient services, including emergency department services, a single nursing home, a panel of primary care physicians, and a panel of specialist physicians. In addition, Bet- terCare must budget for covered care to be delivered out of area when its members are traveling. Thus, to develop its bid, BetterCare has to estimate the amount of payments it will make to this set of providers for the covered population, plus allow for administrative expenses and profits. To keep the illustration manageable, we are excluding pharmacy and ancillary services benefits. (If you like, assume that they are curved out and hence provided under a separate contract.)
Hospital Inpatient Rate I he fee-for-service method is often used to set the in-network hospital inpa- tient capitation rate. This method is based on expected utilization and nego- tiated charges rather than underlying costs, although clearly there should be a link between charges and costs. For example, assume that BetterCare targets
66 Understanding Healthcare Finance Management
350 inpatient days for each 1,000 members, or 0.350 inpatient days per member. Furthermore, BetterCare believes that a fair fee-for-service charge in a competitive environment is $938 per inpatient day. Note that the values chosen for utilization and payment are not based on conventional reimburse- ment experience. Rather, the number of inpatient days reflects a highly man- aged working-age population, and the fee-for-service charge is designed to cover all hospital costs, including profits, in an efficiently run hospital that operates in a highly competitive environment. The inpatient cost PMPM is calculated as follows:
, . , Per member utilization rate x Fee-for-service rate Inpatient cost PMPM = ------------------------------------ -------------------------------
0.350 x $938 12
= $27.36 PMPM.
Thus, using the fee-for-service method, BetterCare estimates inpatient costs for Big Business’s HMO enrollees at $27.36 PMPM.
Other Institutional Rates The rates for out-of-network hospital usage, hospital outpatient surgeries, and emergency department visits, as well as for skilled nursing home stays, were developed using the fee-for-service equivalent method just discussed. Here is a summary of BetterCare’s estimates for these services:
Annual Utilization Fee-for- Capitation Service per 1,000 Members Service Rate Rate PMPM
Out-of-area inpatient days 25 $1,495 $3-ii
Outpatient surgeries 50 1,082 4-5i
Emergency department visits 125 138 1-44
Skilled nursing home days 5 150 0.06
$9-^2
Here, each PMPM capitation rate was calculated by multiplying annual utilization by the fee-for-service rate and then dividing the resulting product first by 1,000 to obtain a per-member amount and then by 12 to get the PMPM rate. The end result is a capitation estimate of $9.12 PMPM
for the services listed. Of course, actual payments to these providers typically would be made on a discounted fee-for-service basis.
Primary Care Rate We use the cost approach to estimate primary physicians’ costs for Big Busi- ness’s enrollees. This approach is the most commonly used method for setting physicians’ payments, and it is based on utilization and underlying costs, as opposed to charges. The starting point is expected patient demand, by specialty, for physicians’ services. This demand is then translated into the number of full-time equivalent (FTE) physicians required per member (enrollee), which depends on physician productivity. Finally, the cost for physician services is estimated by multiplying staffing requirements by the average cost per FTE, including base compensation, fringe benefits, and malpractice premiums. In addition, an amount—usually some dollar amount per member—is added for clinical and administrative support for physicians.
In developing its capitation rate for primary care physicians, Better- Care made the following assumptions:
• On average, each enrollee makes three visits to a primary care physician per year.
• Each primary care physician can handle 4,000 patient visits per year. • Total compensation per primary care physician is $175,000 per year.
Under these assumptions, each enrollee will require 3/4,000 = 0.00075 primary care physicians; hence, each enrollee will require 0.00075 x $175,000 = $131.25 in primary care services annually. Finally, the cost PMPM = $131.25/12 = $10.94. Thus, the rate that BetterCare will pro- pose to Big Business will include $10.94 PMPM for primary care physician compensation. In practice, these calculations usually are first done on a per- 1,000-member basis and then translated into a PMPM basis. For ease, we have simplified the calculations.
Specialty Care Rate The capitation rate for specialists’ care is developed using the cost approach in a similar manner to that used for primary care. Here are BetterCare’s assumptions:
• On average, each enrollee is referred for 1.2 visits to specialty care physicians per year.
• Each specialty physician can handle 2,000 patient visits per year. • Total compensation per specialist is $284,000 per year.
68 Understanding Healthcare Finance Management
Under these assumptions, each enrollee will require 1.2/2,000 = 0.0006 specialists; hence, each enrollee will require 0.0006 x $284,000 = $170.40 in specialists’ services. Finally, the cost PMPM = $170.40/12 = $14.20. Thus, the rate that BetterCare will propose to Big Business will include $14.20 PMPM for specialist physician compensation.
Other Physician-Related Costs Rate Thus far, we have estimated the capitation rate for physicians’ compensation, but we have not accounted for other costs associated with physicians’ practices. First, physicians require, on average, 1.7 FTEs for clinical and administrative support, and each supporting staff member receives an average of $35,000 per year in total compensation. Because the physician requirement to support each member is 0.00075 primary care plus 0.0006 specialists, for a total of 0.00135 physicians, each member will require 0.00135 x 1.7 x $35,000 = $80.33 of physician’s support annually, or $80.33/12 = $6.69 PMPM.
Next, expenditures on supplies—including administrative, medical, and diagnostic supplies—average $10 per visit, and each member is expected to make a total of 4.2 visits per year to primary and specialty care physicians. Thus, the annual cost per member is $42, and the cost PMPM is estimated to be $42/12 = $3.50 PMPM. Finally, overhead expenses, including deprecia- tion, rent, utilities, and so on, are estimated at $6.00 PMPM.
Total Physician Rate BetterCare has estimated numerous categories of costs related solely to physi- cians. For ease, assume now that BetterCare plans to (1) contract with a single medical group practice to provide all physicians’ services and (2) pay the group a capitated rate. The total capitation rate for the medical group would be as follows:
Primary care $ 10.94 PMPM Specialist care 14.20 Support staff 6.69 Supplies 3.50
Overhead 6.00
Subtotal $41.33 PMPM
Profit (10%) 4.13 In-area total $45.46 PMPM Outside referrals 3.40
Total $48.86 PMPM
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The $48.86 PMPM total capitation rate for the medical group is the aggregate of the rates previously developed for physicians’ services, plus nvo additional elements. First, BetterCare believes that a fair profit margin on group practice businesses is 10 percent, so $4.13 PMPM is allowed for profit on the in-network physician subtotal of $41.33 PMPM. Second, §3.40 PMPM is allocated to cover referrals outside the group practice when needed because either a particular specialty is not available in the group or the member is outside the service area. Finally, note that the group might not capitate all its physicians even though it receives a capitated rate from BetterCare.
In general, physician costs, and hence rates, include adjustments for age and gender. An alternative method of developing physician costs—the demographic approach—starts with utilization data already broken down by these categories. Thus, when physician payments are being determined, it is easy to make the payment amount consistent with each physician’s specific patient age-gender mix.
Remember that our goal is to set a premium rate that BetterCare can use to make a bid to cover Big Business’s employees. Thus far, we have estimated the PMPM rates required to pay all the providers needed to serve the popula- tion, both in and out of network. In addition, we are assuming that pharmacy benefits will be handled separately, or carved out, and that the cost of these benefits will be $7.00 PMPM. After all costs have been considered, Better- Care concludes that it can submit a bid of $108.24 PMPM.3
Finding the Total PMPM
Medical costs: Hospital inpatient Other institutional Outpatient prescription drugs Physician care
Total medical costs
$ 27.36 PMPM 9.12
7.00 48.86
$ 92.34 PMPM
HMO costs:
Administration $ 13.85 PMPM
Contribution to reserves/profits Total HMO costs
2.05
$ 15.90 PMPM
Total premium $108.24 PMPM
7° Understanding Healthcare Finance Management
Note that if BetterCare wins the contract from Big Business, the monthly revenue to providers will be somewhat higher (usually about 5 per- cent) than the embedded PMPM rates because enrollees will be required to make copayments for selected services.
Setting the Premium Rates Although we have developed the total PMPM required to cover the medi- cal and administrative costs associated with Big Business’s health plan, this aggregate amount now must be converted into employee premiums. Pre- mium rates generally are categorized and quoted on a tier basis—each tier defines the number of premium categories offered.
Here are some examples of premium tiers:
• One-tier (composite) rates. A single premium is applied regardless of whether the subscriber is single or has any number of eligible dependents.
• Two-tier rates. There are two premium categories—one for single individuals and one for subscribers with dependents (families).
• Three-tier rates. There are three premium categories—one for single individuals; one for subscriber and spouse; and one for a family, which is defined as all other dependent situations.
• Four-tier rates. This tier is similar to the three-tier category, but a fourth premium category is added—subscriber with children but no spouse.
The lower the number of premium categories, the more cross-subsidization takes place. For example, with only one tier, with single subscribers paying the same premium as employees with dependents, single employees are subsidizing the healthcare costs of employees with dependents. Even in higher tiers, it is typi- cal that a family with, say, two children would pay the same premium as a family with, say, five children.
Once the tier is decided on, the next step is to convert the aggregate PMPM into premium rates for each category in the tier. This conversion is accomplished by using a rate ratio, which is the markup factor applied to the single premium rate to obtain each other category rate. For example, in a three-tier plan, the rate ratios might be 2.0 for a subscriber and spouse and 2.7 for a family. In this situation, the single rate would be multiplied by 2.0 to get the subscriber and spouse rate and by 2.7 to get the family rate. The base (single) rate is a function of the premium category composition of the employee population. It must be set so that the premiums collected from all premium rate categories equal the PMPM multiplied by the number of covered lives.
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Note that the rate ratios are somewhat arbitrary. Although they typi- cally do consider family size, they often are based primarily on competitive factors and what the plan sponsor (employer) requests. In general, rate ratios are set so that some cross-subsidization exists, for reasons having to do with employer contributions and coordination of employee benefits. For example, some employers pay 100 percent of the premium for single employees but contribute only a portion for other premium categories. In this situation, subsidization makes family rates more appealing, which increases the number of covered dependents. Also, some subscribers with families choose single coverage and let their spouse include all dependents on the spouse’s health plan. A higher single rate raises revenues for the health plan that enrolls only the subscriber.
In closing, note that BetterCare’s bid will likely be subject to market forces—that is, there will be multiple bidders for Big Business’s health con- tract. For BetterCare’s bid to be accepted, it must offer the right combina- tion of price and quality. If BetterCare’s costs, and hence bid, are too high or its quality too low, it will not secure the contract and will have to reassess its cost and quality structure to ensure that it is competitive on future bids.
SELF-TEST QUESTIONS1. Roughly, what is the allocation of an HMO premium dollar?
2. Briefly describe the following three methods for developing capitation rates: a. Fee-for-service method b. Cost approach c. Demographic approach
3. Of the three approaches, which one do you think would be the most accurate? The easiest to apply in practice?
4. Explain the difference between the total PMPM and a premium rate.
Consumer-Directed Health Plans
Consumer-directed health plans (CDHPs) use financial incentives to influ- ence patient behavior. CDHPs were devised primarily to reduce unnecessary healthcare utilization and, subsequently, overall healthcare spending. Their approach is to couple incentives to save money that would otherwise be spent on higher premiums and elective healthcare services with financing arrange- ments that make patients responsible for purchasing more of their healthcare.
CDHPs have been available since 2003, and although they currently compose a small share of the total insurance market, their use has steadily
72 Understanding Healthcare Finance Management
grown. Rising healthcare costs, which continue to be a vexing problem in healthcare, have largely prompted this increase. Changes in behavior by patients who rely on CDHPs have important implications for providers.
Features of CDHPs CDHPs have two components: a high-deductible health plan (HDHP) and
a personal health financing account. The HDHP typically has a minimum $1,250 (as of 2014) annual deductible. Once a patient has paid the deduct- ible amount out of pocket, the insurance kicks in and provides coverage for the remaining expenses through the end of the year. Due to concerns that high deductibles will encourage patients to forgo preventive services, the majority of CDHPs pay for some preventive services before patients reach the deductible. HDHPs usually have lower premiums.
There are two types of personal health financing accounts: health savings accounts (HSAs) and health reimbursement arrangements (HRAs). Authorized by the Medicare Modernization Act of 2003, HSAs are estab- lished with a trustee (custodian) and can be used only to pay for eligible healthcare expenses. Such accounts must be used in conjunction with quali- fied HDHPs, which in 2014 required a minimum deductible of $1,250 for individuals and $2,500 for families. The details of HDHPs and their costs vary widely by plan. For example, one insurer might offer two differ- ent HDHP alternatives for individual coverage: (1) Plan A, with a $1,150 deductible, a 20 percent copayment, and a $5,800 out-of-pocket maximum and (2) Plan B with a $2,500 deductible, no copayment, and a $3,300 maxi- mum. Contributions to HSAs can be made by both the employer and the employee, although employer contributions are capped by federal law at the level of the deductible. Contributions from both parties are tax exempt.
In 2014, contributions to HSAs, which are deductible for federal income taxes, were limited to $3,300 for individual coverage and $6,550 for family coverage. HSAs are sponsored by financial institutions and health insurers that pay interest on the accounts. Money in HSAs can be used to pay for any “qualified medical expense,” including the cost of dental and vision care and over-the-counter drugs. Interest paid on these accounts, and all amounts used to pay for healthcare services, are not subject to taxes. In addition, the account can be rolled over from year to year with no tax con- sequences until the account is closed, at which time withdrawals are taxable. Employees exercise ownership of their accounts, which are maintained even when employees change employers. This design allows and encourages the use of HSAs as retirement savings accounts, although accrued savings are taxed when they are used for nonmedical expenses.
In contrast, HRAs have limited use as long-term saving mechanisms. Their primary purpose is to reimburse employees for medical expenses. The
employer owns and is the sole contributor to this account. There are no federal limits on employer contributions to HRAs. HRA contributions are also tax exempt, but unlike HSAs, unused funds remain with the employer when the employee changes jobs. Nonmedical expenses are not reimbursed through HRA accounts.
The Rationale for CDHPs Under the first-dollar coverage typical of traditional comprehensive insur- ance plans, patients may not consider the cost of a procedure or doctor visit when making healthcare decisions. Patients may use more healthcare services than they would if they were responsible for paying for each service directly. To pay for higher utilization by patients who are insulated from full costs, traditional insurance plans raise premiums. In the end, employers that pay all or part of employees’ premiums are responsible for all healthcare costs, including those that may be higher than necessary.
There is some evidence that many patients respond to higher cost sharing with lower utilization. The RAND Health Insurance Experiment, the largest controlled study of healthcare utilization, found that patients consume fewer services when subject to higher cost sharing. To better align demand for healthcare with the costs of providing those services, purchasers and insurers designed CDHPs, which apply the RAND experiment findings to the healthcare market.
Another rationale for CDHPs is that putting the onus of paying for care on the patient may make patients more likely to engage in comparative shopping and to focus on obtaining value for their healthcare dollar. Pur- chasers and policymakers hope that comparative shopping among patients will lead to competition among providers that will increase quality and lower costs. Improvements in quality driven by competition for patients depend on establishment of uniform quality metrics that are publicly reported. Patients who pay directly for their healthcare may also follow care regimens prescribed by their doctors more conscientiously to prevent having to pay the costs of further health complications.
Financial Implications for Providers Because CDHPs are relatively new, published evidence of patient and pro- vider outcomes is limited. Initial comparisons of traditional insurance and CDHPs show lower utilization and spending by people who use CDHPs. A 2007 study that compared three-year spending and utilization trends of people enrolled in a CDHP, a preferred provider organization, and a point- of-service (POS) plan found that the CDHP cohort spent considerably more money on hospital care than the POS cohort did (Feldman, Parente, and Christianson 2007).
74 Understanding Healthcare Finance Management
Despite the lack of concrete evidence, economists and policy analysts predict that there could be a number of intended and unintended conse- quences associated with increasing use of CDHPs.
1. If the dynamics observed in the RAND experiment hold true, patients will demand fewer services unrelated to serious health conditions. Demand for preventive care and prescription drugs may decrease. To prevent this harmful result, many plans exclude preventive care and necessary prescription drugs from the deductible. CDHPs may also reduce demand for imaging and elective surgeries. Providers that have a substantial number of patients who use CDHPs may experience reduced volume and reimbursement as a consequence.
2. CDHPs may compel providers in a given geographic area to increase their competitive efforts to attract patients. Patients shopping for value for their healthcare dollar may seek care from providers that convince them that their deductible dollars will be well spent. They may charge lower prices, publicly report higher-quality care, or offer perks to the patient, such as access to electronic medical records. Providers may have to be more transparent about their prices and quality to attract patients.
3. Increased availability of CDHPs may change the demographics of some providers’ patients. The low monthly premium charged by HDHPs may attract younger people who seldom get sick and thus need minimal health coverage. Providers may also notice that a higher proportion of patients with traditional insurance have more severe health conditions. These demographic shifts could change insurer risk pools and might strain health insurance companies’ ability to maintain existing benefit levels.
4. Some providers may experience higher bad-debt expense as some people exhaust their CDHPs and have no way of paying for additional expenses. Providers incur much greater bad-debt loss as a result of healthcare utilization by self-payers than by commercial payers. Furthermore, a healthcare receivable is often difficult and expensive to collect when it becomes a consumer debt.
The Future of CDHPs Banks, credit unions, and insurance companies are making HSAs increas- ingly attractive by letting plan holders invest their unused deposits in mutual funds. Many employers, such as Wal-Mart, are routing their employees into CDHPs. In addition to growth in use by private sector employers, public health plans are increasingly using the CDHP option. Private plans con- tracted to provide service to Medicare beneficiaries had the option of offering
Chapter 2: Health Insurance 75
a Medicare medical savings account as of 1997. However, benefit and enroll- ment restrictions on these plans were limiting participation. The establish- ment of the demonstration medical savings account plan in 2006 created an alternative consumer-directed option that operated more like HSAs in the non-Medicare market. While these plans are heavily adapted to low-income populations, their increasing popularity shows that there is broad interest in increasing the patient’s role in paying for healthcare services.
Consumer-directed healthcare continues to evolve as the published evidence weighs in on whether the health plans are best able to realize lower costs, more patient choice, and higher quality. It may also reveal the circum- stances under which the plans yield the greatest societal benefit. Benefit design and eligibility are highly regulated, but as the evidence emerges, employers and health insurance companies in many markets will likely attempt to enroll more patients in these plans. 'Whether patients take to these plans will depend in large part on how the plans work for them.
1. What are the two components of CDHPs, and how do they work together?
2. What are some advantages of HSAs over HRAs? 3. What perverse healthcare market incentives are created by
traditional indemnity insurance? 4. What is the main finding from the RAND experiment, and how
do CDHPs apply it? 5. What rationales are used to promote CDHP use? 6. How could CDHPs affect providers?
SELF-TEST QUESTIONS
Value-Based Benefit and Insurance Design
Value-based benefit design (VBBD) is the explicit use of plan incentives to encourage enrollee adoption of one or more of the following: (1) appropriate use of high value services, including certain prescription drugs and preven- tive services; (2) adoption of healthy lifestyles, such as smoking cessation or increased physical activity; and (3) use of high-performance providers who adhere to evidence-based treatment guidelines.
Value-based insurance design (VBID) is a system that bases patients’ copayments on the relative value—not the cost—of the clinical intervention. In this setting, cost sharing is still used, but a clinically sensitive approach is explicitly employed to mitigate the adverse health consequences of high out-of-pocket expenditures. The principal tenets of a VBID program are (1) medical services differ in the clinical benefit achieved, and (2) the value of
76 Understanding Healthcare Finance Management
a specific intervention likely varies across patient groups. VBID design con- centrates primarily on the financial incentives and disincentives directed at health plan enrollees. The idea is to align insurance incentives (e.g., copays, deductibles) with the goals of consumer health behavior (e.g., adhering to wellness and prevention guidelines, following guidelines for managing chronic conditions).
SELF-TEST QUESTIONS 1. Briefly describe VBBD and VBID.
2. What are the goals of these insurance designs?
Health Reform and Health Insurance
The ACA introduced a number of provisions to expand insurance coverage and improve insurance affordability and access. These provisions include minimal standards for health insurance policies, the individual mandate, insurance exchanges, price transparency, and Medicaid expansion.
A number of new insurance standards have been specified in the ACA. In terms of coverage, these include the following:
• Children under the age of 19 cannot be denied benefits or coverage because the child has a preexisting condition.
• Children and dependents are permitted to remain on their parents’ insurance plans until their 26th birthday.
• Insurance companies are prohibited from dropping policyholders if they become sick and from denying coverage to individuals due to preexisting conditions.
• Individuals have a right to appeal and request the plan to review denial of payment.
In terms of costs, the standards include the following:
• Insurers are required to charge the same premium rate to all applicants of the same age and geographic location, regardless of preexisting conditions or sex.
• Insurers are required to spend at least 80 percent to 85 percent of premium dollars on health costs and claims instead of on administrative costs and profits. If this is violated, then rebates will be issued to policyholders.
• Lifetime limits on most benefits are prohibited for all new health insurance plans.
Chapter 2: Health Insurance 77
In terms of care, the standards include the following:
• All plans must now include essential benefits, such as ambulatory patient services; emergency services; hospitalization; maternity and newborn care; mental health and substance use disorder services; prescription drugs; laboratory services; preventive and wellness services; and chronic disease management and pediatric services, including oral and vision care.
• Preventive services, childhood immunizations, and adult vaccinations and medical screenings are available free of charge to the patient.
• Individuals are permitted to choose a primary care doctor outside the plan’s network.
• Individuals can seek emergency care at a hospital outside the health plan’s network.
The implications of health reform for financial management and pay- ments to providers are addressed in chapters 1 and 3, respectively. These implications for health insurance are discussed in this section.
Individual Mandate The individual mandate of the ACA went into effect in January 2014. All eligible individuals (i.e., US citizens and legal residents) who are not covered by an employer-sponsored health plan, Medicaid, or Medicare are required to have a health insurance policy or face tax penalties. Individuals are required to maintain minimum essential coverage for themselves and their dependents. Individuals who do not have minimum level of coverage and do not qualify for an exemption are required to pay a penalty to the Internal Revenue Ser- vice at the end of the tax year.
Health Insurance Exchanges Health insurance exchanges (HIEs) are an important part of ensuring health- care access is available to all Americans and legal immigrants. People who are unable to receive health insurance through their employer, the unemployed, or the self-employed can purchase coverage through an exchange. HIEs are online marketplaces, where people can research and review their options and purchase health insurance. By 2016, more than 25 million people are esti- mated to use HIEs to buy coverage.
There are different types of HIEs. Public exchanges are created by state or federal government and are open to both individuals seeking insur- ance for themselves and to small-group employers seeking insurance for their workers. All plans listed on an HIE are required to offer core benefits—called essential health benefits—such as preventive and wellness services, prescription
78 Understanding Healthcare Finance Management
drugs, and hospital stays. Private exchanges, on the other hand, are created by private sector firms, such as a health insurance company. The number of private HIEs may rise as more corporations consider private exchanges as a way for their employees to buy health insurance using a defined contribution. For example, IBM and Time Warner have both decided to move some retir- ees to private exchanges where they can shop for individual coverage using a health retirement account.
Medicaid Expansion One of the provisions of the ACA is the expansion of Medicaid. Nearly all US
citizens and legal residents between the ages of 19 and 64 who have house- hold incomes below 133 percent of the federal poverty level now qualify for Medicaid. This expansion benefits childless adults who previously did not qualify for Medicaid regardless of their income level as well as low-income parents who previously did not qualify even if their children did qualify. As a result, it is estimated that an additional 16 million people would receive coverage through Medicaid.
Originally, under the ACA, Medicaid expansion was mandatory for all states; states that did not comply were to be penalized by the federal govern- ment. However, the US Supreme Court ruled that states can opt out of the Medicaid expansion, leaving this decision to participate in the hands of the state’s leaders. In 2014, 26 states were participating in Medicaid expansion.
The managed Medicaid market may be an area of high growth poten- tial for insurance companies as more states move Medicaid beneficiaries into managed Medicaid plans. The acquisition of Coventry by Aetna and the acquisition of Amerigroup by WellPoint are examples of two leading health plans purchasing the capabilities to serve this growing population. Many insurance companies expected to participate in CMS’s dual-eligible integra- tion pilots in 2014.
Price Transparency To allow for price transparency, all insurance companies are required to post
on HIEs the rates for their various health insurance plans. This will permit individuals and businesses shopping for insurance to compare all plans and rates side by side and select plans that are affordable and meet their needs.
High-Deductible Health Plans Many of those who choose their coverage are opting for HDHPs. HDHPs are
growing in popularity because they are among the least expensive options on the insurance exchanges. In fact, the rate of enrollment in HDHPs has more than doubled since 2009. These plans have low premiums and high deduct- ibles and are linked with HSAs or HRAs, as we described earlier. HDHPs aim to provide individuals with control over their healthcare expenditures. As
Chapter 2: Health Insurance 79
mentioned, individuals enrolled in an HDHP are required to meet minimum deductibles before the plans starts to cover healthcare expenses.
insurance Markets Before health reform, the health insurance industry focused on selling group plans to employers. Now it must recreate itself to cater to a huge, entirely new market of individual consumers. Many insurers have litde idea how costly it is to provide coverage to the new customers, many of whom are not working and have not been insured for a long time (or even at all). One of the biggest challenges that insurance companies will face is attempting to accurately price and run plans without dramatic premium increases. Another implication is that the newly insured often need education about how to use their health plan effectively and how to access different types of care.
Focus on Chronic Care As insurers and providers continue to partner in new accountable care orga- nizations (ACOs), the shared savings programs will likely increasingly focus on consumers with chronic conditions. That means implementing more patient-centered medical homes that aim to manage chronic conditions with specific care pathways that address behavioral health needs and decrease hos- pital admissions and emergency department visits. ACOs and medical homes will also increasingly make use of personal health coaches, who motivate patients on a one-on-one basis and help coordinate patient care with all caregivers.
1. Briefly describe the impact of the ACA on health insurance. SELF-TEST QUESTION
Chapter Key Concepts This chapter presented information on the insurance function, the third- party-payer system, and the reimbursement methodologies used by pay- ers. Here are its key concepts:
• Health insurance is widely used in the United States because individuals are risk averse and insurance firms can take advantage of the law of large numbers.
• Insurance is based on four key characteristics: (1) pooling of losses, (2) payment for random losses, (3) risk transfer, and (4) indemnification.
(continued)
(continued from previous page)
• Adverse selection occurs when individuals most likely to have claims purchase insurance, while those least likely to have claims do not.
• Moral hazard occurs when an insured individual purposely sustains a loss, as opposed to a random loss. In a health insurance setting, moral hazard is more subtle, producing such behaviors as seeking more services than needed and engaging in unhealthy behavior because the costs of the potential consequences are borne by the insurer.
• The major private insurers are Blue Cross and Blue Shield, commercial insurers, and self-insurers.
• The government is a major insurer and direct provider of healthcare services. The two major forms of government health insurance are Medicare and Medicaid.
• Several methods are used by insurers to set premium rates, including the (1) fee-for-service method, (2) cost approach, and (3) demographic approach.
• Consumer-directed health plans (CDHPs) aim to influence patient behavior rather than provider behavior.
• CDHPs reduce the amount of care paid for by insurance companies and increase the amount of care paid for by patients. The plans combine a high-deductible health plan with one of two kinds of accounts from which consumers can draw to pay for care until the deductible is satisfied.
• Value-based benefit design (VBBD) and value-based insurance design (VBID) focus on improving healthcare quality' and decreasing costs. They encourage the use of services when the clinical benefits exceed the costs, and they discourage the use of services when the benefits do not justify the cost.
• The Patient Protection and Affordable Care Act (ACA) has introduced a number of provisions that have made health insurance more accessible. The provisions focus on expanding insurance coverage and improving insurance affordability and access.
• The ACA provisions—including the individual mandate, health insurance exchanges, Medicaid expansion, price transparency, high deductible health plans, new insurance markets, and focus on chronic care—have many implications for health insurance companies and healthcare providers.
The information in this chapter plays a vital role in financial deci- sion making in health services organizations. Thus, it will be used repeat- edly in future chapters.
Chapter 2: Health Insurance
Selected Case
One case in Cases in Healthcare Finance, 5th edition, is applicable to this chapter:
• Case 5: New England Healthcare, which focuses on premium development by a healthcare insurer.
Selected Bibliography
Aron-Dine, A., L. Einav, A. Finkelstein, and M. Cullen. 2012. “Moral Hazard in
Health Insurance: How Important Is Forward hooking Behavior?” National
Bureau of Economic Research Working Paper No. 17802.
Buettgens, M., and M. A. Hall. 2011. “Who Will Be Uninsured After Health Insurance
Reform.” Robert Wood Johnson Foundation. Published March, www.urban.org/ UploadedPDF/1001520-Uninsured-After-Health-Insurance-Reform.pdf.
Buntin, M. B., A. M. Haviland, R. McDevitt, and N. Sood. 2011. “Healthcare Spending and Preventive Care in High-Deductible and Consumer-Directed
Health Plans.” American Journal of Managed Care 17 (3): 222-30. Butorff, C., S. R. Tunis, and J. P. Weiner. 2013. “Encouraging Value-Based Insur-
ance Designs in State Health Insurance Exchanges.” American Journal of Managed Care 19 (7): 593-600.
Feldman, R., S. T. Parente, and J. B. Christianson. 2007. “Consumer-Directed Health
Plans: New Evidence on Spending and Utilization.” Inquiry 44 (1): 26-40. Fendrick, A. M., J. J. Martin, and A. E. Weiss. 2012. “Value-Based Insurance Design:
More Health at Any Price.” Health Services Research 47 (1 pt. 2): 404-13. Holahan, J., C. Carroll, and M. Buettgens. 2011. Health Reform Across the States:
Increased Insurance Coverage and Federal Spending on the Exchanges and Medicaid. Published March, www.urban.org/uploadedpdf/412310-Health- Reform-Across-the-States.pdf.
Waters, T. M., C. F. Chang, W. T. Cecil, P. Kasteridis, and D. Mirvis. 2011. “Impact of High-Deductible Health Plans on Health Care Utilization and Costs.”
Health Services Research 46 (1 pt. 1): 155-72.
Selected Websites
The following websites pertain to the content of this chapter:
• For an extensive source of information on the Medicare program for both patients and providers, see the CMS website at www.cms.gov.
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• The Blue Cross and Blue Shield national organization website contains a great deal of information on the enterprise and its licensed health plans; see www.bluecares.com.
• The health insurance industry provides generic information on healthcare plans at www.ahip.org.
• To learn more about MedPAC and read some of the reports they have prepared for Congress, see www.medpac.gov.
• To obtain more information on health insurance under the ACA, see www. healthcare. gov.
Notes
1. For more information on the basics of insurance, see one of the many excellent insurance textbooks, such as Principles of Risk Management and Insurance by George E. Rejda (Prentice-Hall, 2011) and Fundamentals of Risk and Insurance by Emmett J. Vaughan and Therese M. Vaughan (Wiley, 2013). For more information on health insurance, see Health Insurance by Michael A. Morrisey (Health Administration Press, 2014).
2. Note that the utilization, charge, and cost data used in this section to develop capitation rates are for illustration only and do not necessarily reflect values being used today.
3. According to the 2013 Employer Health Benefits survey undertaken by the Kaiser Family Foundation and Health Research and Educational Trust, the average annual HMO premium for single coverage was $6,030 ($1,081 from the worker and $4,949 from the firm). The average annual HMO premium for family coverage was $16,543 ($5,124 from the worker and $11,419 from the firm). See http:// kaiserfamilyfoundation.files.wordpress.com/2013/08/8466-employer- health-benefits-2013_summary-of-findings 1 .pdf.
CHAPTER
PAYMENTS TO PROVIDERS 3 Learning Objectives After studying this chapter, readers should be able to
• briefly describe coding and its relationship to fee-for-service reimbursement;
• describe generic reimbursement methods used to pay providers and the incentives and risks they create for providers;
• discuss the reimbursement methods used by Medicare; • explain the rationale, design, and incentives of pay-for-performance
systems; and • assess the implications of health reform for payments to providers
of healthcare services.
Introduction
There are various payment methods used to reimburse providers. For instance, providers that are reimbursed on the basis of each patient encounter receive fee-for-service, the term often used to describe conventional reim- bursement. In this chapter, we present alternative reimbursement methods, including capitation and pay for performance. We also consider risk-sharing arrangements, which often accompany capitation. With the implementation of the provisions of the Patient Protection and Affordable Care Act (ACA), new payment methods have emerged that focus on quality of services and are intended to reduce costs. Throughout the chapter, we discuss the incentives to providers created by these systems.
Coding: The Foundation of Fee-for-Service Reimbursement
In practice, the basis for most fee-for-service reimbursement is the patient’s diagnosis (in the case of hospitals) or the procedures performed on the patient (in the case of physicians). Clinicians indicate diagnoses and proce- dures by codes, so a brief background on clinical coding will enhance your understanding of reimbursement.
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Diagnosis Codes The International Classification of Diseases (most commonly known by the abbreviation ICD) is the standard for designating diseases plus a wide variety of signs, symptoms, and external causes of injury. Published by the World Health Organization, ICD codes are used internationally to record many types of health events, including hospital inpatient stays and death certifi- cates. (ICD codes were first used in 1893 to report death statistics.)
The codes are periodically revised; the most recent version is ICD- 10. However, US hospitals are still using a modified version of the ninth revision, called ICD-9-CM, where CM stands for clinical modification. The compliance date for the implementation of ICD-10 was October 2014. The conversion is expected to be time-consuming and costly because ICD-10 has more than five times as many individual codes as ICD-9 has. Of course, the information provided by the new code set is more detailed and complete.
ICD-10 codes are three to seven categories in length. The first three characters refer to the category; characters four to six refer to etiology, anatomic site, severity, or other clinical detail; and character seven refers to extension. For example, S52 describes fracture of forearm, while S52.521A describes torus fracture of lower end of right radius, initial encounter for closed fracture. In practice, the application of ICD codes to diagnoses is com- plicated and technical. Hospital coders have to understand the coding system and the medical terminology and abbreviations used by clinicians. Because of this complexity, and because proper coding can mean higher reimburse- ment from third-party payers, ICD coders require a great deal of training and experience to be most effective.
Procedure Codes While ICD codes are used to specify diseases, Current Procedural Terminol- ogy (CPT) codes are used to specify medical procedures (treatments). CPT codes were developed and are copyrighted by the American Medical Associa- tion. The purpose of CPT is to create a uniform language (set of descriptive terms and codes) that accurately describes medical, surgical, and diagnostic procedures. CPT terminology and codes are revised periodically to reflect current trends in clinical treatments. To increase standardization and the use of electronic medical records, federal law requires that physicians and other clinical providers, including laboratory and diagnostic services, use CPT for the coding and transfer of healthcare information. (The same law also requires that ICD-10-CM codes be used for hospital inpatient services.)
For example, there are ten CPT codes for physician office visits. Five of the codes apply to new patients, while the other five apply to established patients (repeat visits). The differences among the five codes in each category are based on the complexity of the visit, as indicated by three components:
Chapter 3: Payments to Providers 85
history review, (2) extent of examination, and (3) diffi- 'ultv of medical decision making. For repeat patients, the least complex (typi- call shortest) office visit is coded 99211, while the most complex (typically longest) is coded 99215.
Although CPT codes are not as complex as the ICD codes, coders still must have a high level of training and experience to use them correctly. As in [CD coding, correct CPT coding ensures correct reimbursement. Coding is so important that many businesses offer services—such as books, software, education, and consulting—to hospitals and medical practices to improve coding efficiency.
1. Briefly describe the coding system used in hospitals (ICD codes) and medical practices (CPT codes).
2. What is the link between coding and reimbursement?
SELF-TEST QUESTIONS
Generic Reimbursement Methods
Regardless of the payer, only a limited number of payment methods are used to reimburse providers. Payment methods can be categorized into two broad classifications: (1) fee-for-service and (2) capitation. Under fee-for-service, of which many variations exist, the greater the amount of services provided, the higher the amount of reimbursement. Under capitation, a fixed payment is made to providers for each covered life, regardless of the number of services provided. In this section, we consider the mechanics, incentives to providers, and the financial risk of the alternative reimbursement methods.
Fee-for-Service Methods The three primary fee-for-service methods are (1) cost-based reimbursement, (2) charge-based reimbursement, and (3) prospective payment.
Cost-Based Reimbursement Under cost-based reimbursement, the payer agrees to reimburse the pro- vider for the costs incurred in providing services to the insured population. Reimbursement is limited to allowable costs, usually defined as costs directly related to the provision of healthcare services. Nevertheless, for all practical purposes, cost-based reimbursement guarantees that a provider’s total costs will be covered by payments from payers. Typically, the payer makes periodic interim payments (PIPs) to the provider, and a final reconciliation is made after the contract period expires and all costs have been processed through the provider’s accounting system.
86 Understanding Healthcare Finance Management
During its early years (1966-1982), Medicare reimbursed providers on the basis of costs incurred. Now most hospitals are reimbursed by Medicare and by other payers, using a per diagnosis prospective payment system (see below). An exception is critical access hospitals, which are 1,332 small, rural hospitals that provide services to remote populations without easy access to other hospitals. Critical access hospitals receive cost-based reimbursement for the services provided to Medicare beneficiaries (and Medicaid beneficiaries in some states).
Charge-Based Reimbursement When payers pay billed charges, they pay according to a rate schedule estab- lished by the provider, called a chargemaster. To a certain extent, this reim- bursement system places payers at the mercy of providers in regard to the cost of healthcare services, especially in markets where competition is limited. In the early days of health insurance, all payers reimbursed providers on the basis of billed charges. Some insurers still reimburse providers according to billed charges, but the trend is toward other, less generous reimbursement meth- ods. As this trend continues, the only payers expected to pay billed charges are self-pay, or private-pay, patients. Even then, low-income patients often are billed at rates less than charges.
Some payers that historically reimbursed providers on the basis of billed charges now pay by negotiated, or discounted, charges. This is especially true for insurers that have established managed care plans such as health maintenance organizations (HMOs) and preferred provider organizations (PPOs). HMOs and PPOs, as well as some conventional insurers, have bar- gaining power because of the large number of patients that they bring to a provider, so they can negotiate discounts from billed charges. Such discounts generally range from 20 percent to 50 percent, or even more, of billed charges. Sometimes sliding-scale discounts are used, the amount of which is tied to the amount of volume generated by the payer—the greater the vol- ume, the higher the discount.
Prospective Payment In a prospective payment system, the rates paid by payers are determined by the payer before the services are provided. Furthermore, payments are not directly related to reimbursable costs or chargemaster rates. Here are some common units of payment used in prospective payment systems:
1. Per procedure. Under per procedure reimbursement, a separate payment is made for each procedure performed on a patient. Because of high administrative costs associated with this method when applied to complex diagnoses, per procedure reimbursement is more commonly used in outpatient than inpatient settings.
Chapter 3: Payments to Providers 87
2 Per diagnosis. In per diagnosis reimbursement, the provider is paid a rate that depends on the patient’s diagnosis. Diagnoses that require higher resource utilization and hence are more costly to treat have higher reimbursement rates. Medicare pioneered this basis of payment in its diagnosis-related group (DR.G) system, which it first used for hospital reimbursement in 1983. (Reimbursement on the basis of DRG is discussed in detail in the section on Medicare.)
3. Per diem (per day). If reimbursement is based on a per diem rate, the provider is paid a fixed amount for each day service is provided, regardless of the nature of the services. This type of reimbursement is applicable only to inpatient settings. Note that per diem rates can be stratified. For example, a hospital may be paid one rate for a medical/ surgical day, a higher rate for a critical care unit day, and yet a different rate for an obstetric day. Stratified per diems recognize that providers incur different daily costs for providing different types of care.
4. Bundled (global) pricing. Under bundled pricing, payers make a single prospective payment that covers all services delivered in a single episode, whether for the services rendered by a single or by multiple providers. For example, a bundled payment may be made for all obstetric services associated with a pregnancy provided by a single physician, including all prenatal and postnatal visits as well as the delivery. For another example, a bundled payment may be made for all physician and hospital services associated with a cardiac bypass operation. Finally, note that, at the extreme, a global payment may cover an entire population, which, in effect, is a capitation payment as described in the next section.
Capitation Under capitation, providers receive a fixed fee for each patient enrolled in the capitated plan. This fee is the same for all patients, regardless of the amount or intensity of care a patient seeks. This reimbursement methodol- ogy requires a different approach to financial management decision making than that used under conventional reimbursement. The basic cornerstones of finance—such as discounted cash flow analysis, risk and return, and opportu- nity costs—remain unchanged, but the environment in which these concepts are applied is altered under a capitated system.
Formally defined, capitation is a flat periodic payment per enrollee to a healthcare provider; it is the sole reimbursement for services provided to a defined population. The word capitation is derived from the term per capita, which means per person (literally, per head). Often, capitation payments are expressed as some dollar amount per member per month (PMPM). Here, the word member typically means an enrollee in a managed care plan—usually an HMO.
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For example, a primary care physician may receive a capitated pay- ment of $20 PMPM for attending to the healthcare needs of 250 members of BetterCare, a regional HMO. Under this contract, the physician would receive $20 x 250 x 12 = $60,000 in total capitation payments over the year. The physician then would have to cover all primary care services offered to patients specified in the contract as well as all administrative and other prac- tice costs associated with providing that care.
Capitated payments are adjusted for age and gender, so unlike the example here, PMPM payments would not be exactly the same for all 250 members of the health plan. Payments can also be risk-adjusted, an actuarial process that incorporates health status into the PMPM amount. This process attempts to match the capitated rate to the expected healthcare needs, and hence costs, of the patient.
The widespread use of capitation began in the late 1980s among managed care organizations, which adopted the system as one tool of many designed to reduce healthcare costs. By changing the unit of payment from per sendee to per member, capitation removed the incentive to increase reve- nues by increasing service volume. Although the use of capitation did reduce the growth rate of healthcare costs for a few years, cost increases ultimately returned to the old pattern of being about twice that of general inflation. Thus, payer enthusiasm for capitated payments waned, and the prediction that capitation would dominate the payment landscape never came true.
However, under the ACA, some accountable care organizations (ACOs) are paying providers a capitated rate that is tied to quality of care. The theory is that fixed payments would discourage the provision of unnec- essary care, and quality-based bonuses would ensure that needed services are provided. Although the ACO concept is in its infancy, one possible structure would be an organization composed of both hospitals and physicians who would be paid to care for all the health needs of a large group of patients—at least 5,000. In ACOs, doctors and hospitals would be paid on the basis of their ability to manage costs yet meet established quality-of-care indicators. In effect, their pay would be based on improving patient health rather than on the amount of care provided. If an ACO failed to meet certain quality and cost-savings targets, its providers would receive lower payments. On the flip side, an ACO would be rewarded for keeping patients satisfied and meeting national quality standards, such as ensuring that patients with diabetes are monitored and women obtain mammograms as specified for age and risk fac- tors. In the next section, we discuss more fully the implications of a capitation system and the incentives it creates for providers.
Capitation offers several financial benefits to providers. Capitation revenues are more predictable and timely than revenues from conventional payment methodologies based on volume. These factors facilitate financial
Chapter 3: Payments to Providers
management and budgeting processes in the organization. Capitation pay- ments are received before services are rendered, so, in effect, payers are extending credit to providers rather than vice versa, as under conventional reimbursement. This arrangement will improve some financial ratios, such as time (days) in accounts receivable, and may help an organization’s bond rating. Finally, capitation typically reduces the burden of reimbursement paperwork and hence lowers administrative costs.
Two other implications of capitated payment systems are worth men- tioning. First, capitation encourages wellness and prevention as opposed to treatment. This emphasis may require changes to staff mix because physician extenders—such as nurse practitioners and physician assistants—may be more cost-effective than physicians in delivering wellness and prevention services. Second, historical utilization rates based on conventional reimbursement methodologies are not good predictors of future utilization when the pay- ment system is capitation or some other system that encourages aggressive utilization control.
1. Briefly describe the following reimbursement methods: a. Cost based b. Charge based and discounted charges c. Per procedure d. Per diagnosis e. Per diem f. Bundled (global) g. Capitation
2. What is the major difference between fee-for-service and capitation?
SELF-TEST QUESTIONS
Financial Incentives to Providers
Incentives Under Fee-for-Service Reimbursement Providers, like individuals and other businesses, react to the incentives cre- ated by the financial environment. For example, individuals can deduct mort- gage interest from income for tax purposes, but they cannot deduct interest payments on personal loans. Loan companies have responded by offering home equity loans that are a type of second mortgage. The tax laws assumed that these loans would be used to make home ownership more accessible, but in reality they are generally used for other purposes, including financing vacations, cars, and appliances. In this situation, tax laws created incentives
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for consumers to have mortgage debt rather than personal debt, and the mortgage loan industry responded accordingly.
In the same vein, the incentives offered by alternative reimbursement methods influence provider behavior. Under cost-based reimbursement, providers are given a “blank check.” If payers reimburse providers for all costs, the incentive is to incur costs. Facilities will be lavish and conveniently located, and staff will be available to ensure that patients are given deluxe treatment. Furthermore, as in billed-charges reimbursement, non-necessary services will be provided because more services lead to higher costs, which translate to higher revenues.
Under charge-based reimbursement, providers have an incentive to set high chargemaster rates, which leads to high revenues. However, in competi- tive markets, there is a constraint on how high providers can go, and insurers with negotiating power will demand discounts. Because billed charges is a fee-for-service type of reimbursement, under which more services result in higher revenue, there is a strong incentive to provide the highest possible amount of services. In essence, providers can increase volume, and hence revenues, by churning—creating more visits, ordering more tests, extending inpatient stays, and so on. Although charge-based reimbursement encourages providers to contain costs, the incentive is weak because, typically, charges can be increased more easily than costs can be reduced. Note, however, that discounted charge reimbursement places additional pressure on profitability and hence creates increased incentive for providers to lower costs.
Under prospective payment reimbursement, provider incentives are altered. First, under per procedure reimbursement, the profitability of indi- vidual procedures varies depending on the relationship between the actual costs incurred and the payment for that procedure. Providers, usually physi- cians, have an incentive to perform procedures that have the highest profit potential. Furthermore, the more procedures performed, the better, because each procedure typically generates additional profit. The incentives under per diagnosis reimbursement are similar. Providers, usually hospitals, seek patients with diagnoses that have the greatest profit potential and discourage (even discontinue) services that have the least profit potential. Furthermore, to the extent that providers have some flexibility in assigning diagnoses to patients, an incentive exists to up co de diagnoses from the actual one to another that receives greater reimbursement.
Under all prospective payment methods, providers have an incentive to reduce costs because the amount of reimbursement is fixed and indepen- dent of the costs actually incurred. When per diem reimbursement is used, particularly with hospitals, providers have an incentive to increase length of stay. Because the early days of a hospitalization are typically more costly to
Chapter 3: Payments to Providers 91
the provider than the later days, the later days are more profitable. However, as mentioned previously, hospitals have an incentive to reduce costs during each day of a patient’s stay.
Under bundled (global) pricing, providers are not reimbursed for a series of separate services, which is called unbundling. For example, a physi- cian’s treatment of a fracture can be bundled and billed as one episode, or it can be unbundled, with separate bills submitted for diagnosis, X-rays, setting the fracture, removing the cast, and so on. The rationale for unbundling is usually to provide more detailed records of treatments rendered, but often the result is higher total charges for the parts than would be charged for the entire “package” of services. Also, when applied to multiple providers for a single episode of care, global pricing forces involved providers (e.g., physi- cians and a hospital) to jointly offer the most cost-effective treatment. A joint view of cost containment may be more effective than separate attempts by each provider to minimize its treatment costs because lowering costs in one phase of treatment can increase costs in another.
Incentives Under Capitation Reimbursement Under fee-for-service, profits are proportional to volume. The key to pro- vider success is to work harder, increase utilization, and increase profits. Capitation reverses the actions that providers must take to ensure financial success, and providers must adjust accordingly.
Under capitation, profitability relies on efficiency and cost-effective treatment plans to keep costs low. The key to profitability is to work smarter and decrease utilization. Thus, only procedures that are medically necessary should be performed, and treatment should take place in the lowest-cost set- ting that can provide the appropriate quality of care. Furthermore, capitated providers have an incentive to promote health rather than just treat illness and injury because a healthier population consumes fewer healthcare services.
Comparison of Financial Incentives to Providers The financial incentives of fee-for-service and capitation reimbursement are compared in Exhibit 3.1. The exhibit depicts costs and revenues under the two payment systems. Under both, total costs (TC)—fixed costs (FC) plus variable costs (VC)—are tied directly to volume, meaning greater service volumes result in higher total costs. The revenue lines, which determine how profits and losses are realized, differ between the two systems. Under fee-for-service, the revenue line (Rev) starts at the origin and slopes upward. At zero volume, the provider receives zero revenue. At any positive volume, greater volume results in higher revenue. Under capitation, the revenue line is horizontal, assuming a fixed number of enrollees—meaning revenues are
92 Understanding Healthcare Finance Management
EXHIBIT 3.1 Revenue and
Cost Structures Under Fee-for-
Service and Capitation
constant across different levels of volume. In each graph, breakeven (BE) occurs when revenues equal total costs.
However, as shown in Exhibit 3.1, a profound difference exists in how the profits and losses occur. For fee-for-service, all volumes to the left of breakeven produce a loss for the provider, while all volumes to the right of breakeven produce a profit. Thus, the incentive for providers is to raise utili- zation because increased volume leads to greater profits. The graph of capita- tion costs and revenues shows that all volume levels to the left of breakeven produce a profit, whereas all volumes to the right of breakeven result in a loss. Under capitation, providers have an incentive to decrease utilization because lower volume leads to higher profits. The only way to increase rev- enues is to increase the number of covered lives (enrollees).
SELF-TEST QUESTIONS 1. What financial incentives to providers are created by each of the
following reimbursement methods: a. Cost based b. Charge based and discounted charges c. Per procedure d. Per diagnosis e. Per diem f. Bundled (global) g. Capitation
2. What is the major difference between the financial incentives to providers of fee-for-service and capitation?
Chapter 3: Payments to Providers 93
Financial Risks to Providers
A key issue facing providers is the impact of the different reimbursement methods on financial risk. For now, think of financial risk in terms of the effect that the reimbursement methods have on profit uncertainty—the greater the chances of losing money, the higher the risk.
Risks Under Fee-for-Service Reimbursement Cost- and charge-based reimbursements are the least risky for providers because payers more or less ensure that costs will be covered and hence profits will be earned. In cost-based systems, costs are automatically covered, and a profit component typically is added. In charge-based systems, provid- ers typically can set charges high enough to ensure that costs are covered, although discounts introduce uncertainty into the reimbursement process.
In all reimbursement methods except cost-based, providers bear the cost-of-service risk in that costs can exceed revenues. However, a primary difference among the reimbursement types is the provider’s ability to influ- ence the revenue-cost relationship. If providers set charge rates for each type of service provided, they can most easily ensure that revenues exceed costs. Furthermore, if providers have the power to set rates above those that would exist in a truly competitive market, charge-based reimbursement could result in higher profits than might cost-based reimbursement.
Prospective payment adds a second dimension of risk to reimburse- ment contracts because the bundle of services needed to treat a particular patient may be more extensive than that assumed in the payment. However, when the prospective payment is made on a per procedure basis, risk is mini- mal because each procedure will produce its own revenue. When prospec- tive payment is made on a per diagnosis basis, provider risk increases. If, on average, patients require more intensive treatments, or inpatients a longer length of stay (LOS), than assumed in the prospective payment amount, the provider must bear the added costs.
When prospective payment is made on a per diem basis, even when stratified, one daily rate usually covers a large number of diagnoses. Because the nature of the services provided could vary widely—because of both vary- ing diagnoses and intensity differences within a single diagnosis—the pro- vider bears the risk that costs associated with the services provided on any day may exceed the per diem rate. Patients with complex diagnoses and greater intensity tend to remain hospitalized longer, and per diem reimbursement does differentiate among different LOSs, but the additional days of stay may be insufficient to make up for the increased resources consumed. In addition, providers bear the risk that the payer, through its utilization review process, will constrain LOS and hence increase intensity during the days that a patient
94 Understanding Healthcare Finance Management
is hospitalized. Under per diem, compression of services and shortened LOS can put significant pressure on providers’ profitability.
Under bundled pricing, a more inclusive set of procedures, or provid- ers, are included in one fixed payment. Clearly, the more services that must be rendered for a single payment—or the more providers that have to share a single payment—the more providers are at risk for intensity of services.
Risks Under Capitation Reimbursement Under capitation, providers assume utilization risk along with the risks assumed under the other reimbursement methods. The assumption of uti- lization risk has traditionally been an insurance function rather than a pro- vider function. In the traditional fee-for-service system, the financial risk of providing healthcare is shared between purchasers and insurers. Hospitals, physicians, and other providers bear negligible risk because they are paid on the basis of the amount of services provided. Insurers bear short-term risk in that payments to providers in any year can exceed the amount of premiums collected. However, poor profitability by insurers in one year usually can be offset by premium increases to purchasers the next year, so the long-term risk of financing the healthcare system is borne by purchasers. Capitation, how- ever, places the burden of short-term utilization risk on providers.
Comparison of Financial Risks to Providers When provider risk under different reimbursement methods is discussed in this descriptive fashion, an easy conclusion to make is that capitation is by far the riskiest to providers, while cost- and charge-based reimbursement are by far the least risky. Although this conclusion is not a bad starting point for analysis, financial risk is a complex subject, and its surface has just been scratched. One of the key issues throughout the remainder of this text is financial risk, so readers will see this topic over and over. For now, keep in mind that different payers use different reimbursement methods. Thus, providers can face conflicting incentives and differing risk, depending on the predominant method of reimbursement.
All prospective payment methods involve a transfer of risk from insurers to providers; that risk increases as the payment unit moves from per procedure to capitation. The added risk does not mean that providers should avoid such reimbursement methods; indeed, refusing to accept contracts with prospective payment provisions would be tantamount to organizational suicide. However, providers must understand the risks involved in prospective payment arrange- ments, especially their effect on profitability, and make every effort to negoti- ate a level of payment that is consistent with the risks incurred.
In closing, note that most providers face risk of nonpayment, regard- less of reimbursement method. If a user of healthcare services does not have insurance, the patient or patient’s family is responsible for payment of total
r Chapter 3: Payments to Providers
billed charges (or some lesser agreed-upon amount). Because people with- ollt health insurance tend to be poor, many of them find it difficult, if not impossible, to pay for healthcare services, which can quickly amount to tens of thousands of dollars. There are two categories of nonpaying patients:
] patients who have the capacity but are unwilling to pay; the lost revenue attributable to this class of nonpayer is called a bad debt loss, and
2 patients who do not have the capacity (are unable) to pay; the lost revenue attributable to these patients is called a charity, or indigent, care loss.
These classifications are important for two reasons. First, the two types of nonpayment are handled differently on the income statement. Second, it is important that not-for-profit providers be able to document their contribu- tions to society, and one of the most important contributions is willingness to treat indigent patients.
1. What financial risks to providers are created by each of the following reimbursement methods: a. Cost based b. Charge based and discounted charges c. Per procedure d. Per diagnosis e. Per diem f. Bundled (global) g. Capitation
2. What is the major difference between the financial risks to providers of fee-for-service and capitation?
SELF-TEST QUESTIONS
Reimbursement Methods Used by Medicare1
Hospital Acute Inpatient Services The inpatient prospective payment system (IPPS) pays per discharge rates, which include two national base payment rates (operating and capital expenses) adjusted to account for two factors that affect the costs of providing care: (1) the patient’s condition and treatment and (2) market conditions in the facility’s geographic location. Discharges are assigned to one of 751 Medicare severity diagnosis-related groups (MS-DRGs), which are groups of patients with similar clinical problems who are expected to consume similar amounts of hospital resources. Each MS-DRG has a relative weight that reflects the expected relative
96 Understanding Healthcare Finance Management
cost of inpatients in that group. The payment rates for MS-DRGs in each local market are determined by adjusting the base payment rates to reflect the local input-price level and then multiplying them by the relative weight for each MS- DRG. The operating and capital payment rates are increased for facilities that operate an approved resident training program or that treat a disproportionate share of low-income patients. Rates are reduced for various transfer cases, and outlier payments are added for cases that are extraordinarily costly. Both operat- ing and capital payment rates are updated annually. (See Exhibit 3.2.)
The IPPS payment rates are intended to cover the costs that reasonably efficient providers would incur in providing high-quality care. If the hospital is able to provide the services for less than the fixed reimbursement amount, it can keep the difference. Conversely, if a Medicare patient’s treatment costs are more than the reimbursement amount, the hospital must bear the loss.
EXHIBIT 3.2
Medicare Hospital Acute
Inpatient Services Payment
System
Adjusted for geographic factors
Note: MS-DRG (Medicare severity diagnosis-related group), LOS (length of stay), IPPS (inpa- tient prospective payment system). Capital payments are determined by a similar system. * Transfer policy for cases discharged to post-acute care settings applies for cases in 275 selected MS-DRGs. ** Additional payment made for certain rural hospitals. Source: Reprinted from MedPAC. 2014. “Hospital Acute Inpatient Services Payment System.” Figure 1. Revised October, www.medpac.gov/documents/payment-basics/hospital- acute- inpatient-services-payment-system-izj.pdf?sfvrsn=o.
Chapter 3: Payments to Providers 97
Outpatient Hospital Services The outpatient prospective payment system (OPPS) is essentially a fee schedule. The unit of payment under the OPPS is the individual service as identified by the Healthcare Common Procedure Coding System (HCPCSf which contains codes for about 6,700 distinct services. The Centers for Medicare & Medicaid Services (CMS) groups sendees into ambulatory payment classifications (APCs) on the basis of clinical and cost similarity. Each APC has a relative weight that measures the resource requirements of the service and is based on the median cost of ser- vices in that APC. CMS sets payments for individual APCs using a conversion fac- tor that translates the relative weights into dollar payment rates and adjustments for geographic differences in input prices. Hospitals also can receive additional payments in the form of outlier adjustments for extraordinarily high-cost services and pass-through payments for some new technologies. (See Exhibit 3.3.)
Physician Services Medicare pays for physician services on the basis of the physician fee sched- ule. The unit of payment is the individual service, such as an office visit or a diagnostic procedure, which is classified and reported to CMS according to HCPCS. Payment rates are based on relative weights called relative value units (RVUs), which account for the amount of work required to provide a service, expenses related to maintaining a practice, and liability insurance costs. The values given to these three types of resources are adjusted to reflect
Adjusted for Payment adjusted for Policy adjustments for geographic factors complexity of service hospitals that qualify
EXHIBIT 3.3
Medicare Outpatient Hospital Services Payment System
Note: APC (ambulatory payment classification), SCH (sole community hospital). The APC is the service classification system for the outpatient prospective payment system. *Medicare adjusts outpatient prospective payment system payment rates for 11 cancer hospitals so that the payment-to-cost ratio (PCR) for each cancer hospital is equal to the average PCR for all hospitals. Source: Reprinted from MedPAC. 2014. “Outpatient Hospital Services Payment System.” Figure 1. Revised October, www.medpac.gov/documents/payment-basics/outpatient-hospital- services- Payment-system.pdf?sfvrsn=o.
variations in local input prices, and the total is multiplied by a standard dol- lar amount—called the conversion factor—to arrive at the payment amount. Medicare’s payment rates may also be adjusted to reflect provider characteris- tics, geographic designations, and other factors. The provider is paid the final amount, less any beneficiary coinsurance. (See Exhibit 3.4.)
Ambulatory Surgery Centers In January 2008, Medicare began paying for surgery-related facility services provided in ambulatory surgery centers. The unit of payment is the individual surgical procedure. Each of the nearly 3,600 approved procedures is assigned an APC. These APCs are the same payment groups used in OPPS. The rela- tive weights for most procedures in the ambulatory surgery center payment system are the same as the relative weights in OPPS. Like OPPS, the ambula- tory surgical center payment system sets payments for individual services using a conversion factor and adjustments for geographic differences in input prices.
Inpatient Rehabilitation Facilities In January 2002, CMS implemented the inpatient rehabilitation facility prospec- tive payment system. Inpatient rehabilitation facilities are paid predetermined
EXHIBIT 3.4 Medicare
Physician Services Payment
System
Total RVUs from physician fee schedule
Conversion factor
r • ’’ iComplexity ■ 1 1 i :of service i and expenses j
Work RVU ii
PE RVU
i i PLI RVU
i : i X +i X i + i X 1 j—
► Payment
modifier -*Adjustedfor: i iGeographic j 1 1 1
i i i =
Adjusted fee schedule
payment rate
factors ;
Work GPCI
!
PE GPCI
i i
PLI GPCI
1 : • . . . !
...J 1
! !
Payment
Note: RVU (relative value unit), GPCI (geographic practice cost index), PE (practice expense), PLI (professional liability insurance), HPSA (health professional shortage area). This figure depicts Medicare payments only. The fee schedule lists separate PE RVUs for facility and nonfacility settings. Fee schedule payments are reduced when specified nonphysician practitioners bill Medicare separately, but not when services are provided “incident to” a physician. Source: Reprinted from MedPAC. 2014. “Physician and Other Health Professionals Payment System.” Figure 1. Revised October, http://medpac.gov/documents/payment- basics/physician- and-other-healthprofessionalspayment-system-i4.pdf?sfvrsn=o.
Chapter 3: Payments to Providers 99
discharge rates based primarily on the patient’s condition (diagnoses, func- nonal and cognitive statuses, and age) and market area wages. Discharges are issigned to one of 92 intensive rehabilitation categories called case-mix groups (CMGsf which are groups of patients with similar- clinical problems. Within each of these CMGs, patients are further categorized into one of four tiers on die basis of any comorbidities they have; each tier receives a specific payment that reflects the costliness of patients in that tier relative to others in the CMG.
Psychiatric Hospital Services In January 2005, CMS implemented the inpatient psychiatric facility prospec- tive payment system, which pays psychiatric hospitals the per diem routine, ancillary, and capital costs associated with providing covered inpatient psychi- atric services. A base per diem payment is adjusted to account for cost-of-care differences related to patient characteristics (age, diagnosis, comorbidities, and length of stay) and facility characteristics (local wages, geographic loca- tion, teaching status, and emergency department status).
Skilled Nursing Facility Services In July 1998, CMS implemented a prospective payment system for skilled nursing facilities (SNFs) that pays facilities a predetermined daily rate for each day of care, up to 100 days. The rates are expected to cover all operating (skilled nursing care, rehabilitation services, and other goods and services) and capital costs that efficient facilities would be expected to incur in providing most SNF services. Various high-cost, low-probability ancillary services are covered separately. Patients are assigned to one of 66 categories called resource utilization groups (R UGs) on the basis of patient characteristics and service use that are expected to require similar resources. Nursing and therapy weights are applied to the base payment rates of each RUG. Daily base payment rates are also adjusted to account for geographic differences in labor costs.
Home Health Care Services hi October 2000, CMS implemented a prospective payment system that pays home health agencies a predetermined rate for each 60-day episode of home health care. If fewer than five visits are delivered during a 60-day episode, the home health agency is paid per visit by visit type. Patients who receive five or more visits are assigned to one of 153 home health resource groups, which are based on clinical and functional status and service use as measured by the Outcome and Assessment Information Set (OASIS). The payment rates are adjusted to reflect local market input prices and special circumstances, such as high-cost outliers.
Critical Access Hospitals The Balanced Budget Act of 1997 created a new category of hospitals called critical access hospitals (CAHs). Each of 1,332 CAHs is limited to 25 beds,
100 Understanding Healthcare Finance Management
and patients are limited to a four-day length of stay. CAHs primarily operate in rural areas. Unlike most other acute care hospitals (which are paid through prospective payment systems), CAHs are paid by Medicare on the basis of each hospital’s reported costs. Each CAH receives 101 percent of the costs it incurs in providing outpatient, inpatient, laboratory and therapy services, and post-acute care in the hospital’s swing beds. The cost of treating Medicare patients is estimated using cost accounting data from Medicare cost reports.
Hospice Services Medicare pays hospice providers a daily rate for each day a beneficiary is enrolled in the hospice benefit. Medicare makes a daily payment, regard- less of the amount of services provided and on days when no services are provided. The daily payment rates are intended to cover costs of providing services included in patients’ care plans. Payments are made according to a fee schedule for four different categories of care: routine home care, continu- ous home care, inpatient respite care, and general inpatient care. The four categories of care differ by the location and intensity of the services provided, and the base payments for each category reflect variation in expected input cost differences.
Ambulance Services Medicare pays for ambulance services using a dedicated fee schedule, which has payment rates for nine categories of ground and air ambulance transport. CMS considers historical costs as a basis to establish relative values for each payment category. These relative values are multiplied by a dollar amount that is standard across all nine categories and then adjusted for geographic differences. This amount is added to a mileage payment to arrive at the total ambulance payment amount. Medicare payments for ambulance services may also be adjusted by one of several add-on payments based on additional geo- graphic characteristics of the transport.
SELF-TEST QUESTIONS 1. What is the IPPS, and how does it work?
2. What is the OPPS, and how does it work? 3. How are physicians reimbursed for providing services to Medicare
patients?
Pay for Performance
Pay for performance (P4P) is a general term that refers to any reimbursement scheme that makes meeting performance standards a prerequisite for some
Chapter 3: Payments to Providers 101
or all of a provider’s payment. Thus, risk pools are a type of P4P system. P4P uses financial incentives to encourage behaviors and influence outcomes that the payer considers desirable. It can be implemented by insurers or purchas- ers to improve quality and/or increase productivity among their contract providers. There are examples of P4P in both public and private insurance reimbursement of physician practices, hospitals, long-term care providers, and home health agencies. Providers may also use P4P to determine reim- bursement of staff in their own organizations. Organizations vary in the ways they pay for performance in two main respects: (1) how they define perfor- mance and (2) how they allocate rewards.
Defining Performance P4P requires selection of performance measures and specification of levels of performance. Public and private insurers usually define performance as achieving a specific level of quality. Depending on the program’s aims and the data available, some combination of four quality dimensions are usually measured: outcome, process, patient satisfaction, and structure.
Outcome measures reveal whether a provider attained a certain level of healthcare results over a defined period. An example of an outcome measure is the percentage of healthy babies born at a hospital. Numerous factors influ- ence health outcomes beyond provider care. Unadjusted outcome measures are potentially biased to favor providers with healthier patients, so P4P mea- sures are frequently adjusted according to risk factors in a patient population. At a minimum, risk adjustment includes age and gender, while more complex adjustment may include health status and other demographic characteristics of the patient population.
Processes of care linked to desired health outcomes are measured through process measures. Most process measures circumvent the need to adjust for risk because providers have more control over whether they follow a particular process than they have over the outcome of that process. Process measures typically report the ratio of processes actually performed to the total times the process should have been performed—for example, the percentage of emergency patients with chest pain who receive aspirin.
Patients’ satisfaction can also be an indicator of quality. Patient sat- isfaction measures focus on patients’ versus providers’ evaluation of the care they experience. Patient satisfaction measures, such as the courtesy afforded to patients by staff, may reflect on more aspects of the care delivered than specific outcome and process measures; however, these types of data are more subjective and may be harder to interpret than outcome and process measures.
Finally, structure measures may be used as indirect measures of quality. For example, a payer may decide that implementation of an electronic health
______________________________________
record will improve quality of care. As part of a P4P program, it may provide financial incentives for investment in information technology.
Providers that use P4P to determine staff compensation in their own organizations often include productivity and financial measures in their defi- nition of performance. Productivity measures, such as the average number of patient visits per day, provide incentives to treat more patients by working faster or longer hours. Financial measures, such as revenue per physician, provide incentives to increase the total revenue of the organization.
Allocating Rewards P4P programs vary with regard to reward criteria and the amount that they reward. In general, P4P rewards may be earned for three types of per- formance: relative, benchmark, and improvement. Relative performance measures how a provider performed in comparison to other providers; for example, a provider that scored better than 75 percent of its peers on a particular measure receives a reward. Benchmark performance is based on whether a provider attained a preidentified score or level of performance. Improvement performance measures how much a provider’s performance has improved over its performance in a previous period; for example, a provider that increased its score on a particular measure by more than 10 percent receives a reward.
For examples of the three types of performance on which P4P awards may be based, consider cardiac care. When patients go to an emergency department with chest pain, most are supposed to (but do not always) receive aspirin. A P4P might specify that, over a certain period, a provider will receive a reward if it: (1) administers aspirin to appropriate patients more often than 90 percent of its peers do (relative performance); (2) administers aspirin to more than 95 percent of appropriate patients (benchmark performance), or (3) increases the percentage of patients who receive aspirin appropriately from 80 percent to 90 percent (improvement performance).
The reward amount can also be determined in several ways. Payment may be a specified bonus for attainment of performance (or deduction for nonattainment). The reward can be calculated as a percentage increase (or decrease) of the normal reimbursement amount. Alternatively, a set amount might be distributed on a per patient basis, in which case the total reward would depend on eligible patient volume. The magnitude of the P4P reward should be enough to provide a meaningful incentive for the desired behavior but not so much that it encourages neglect of other unmeasured perfor- mance. Many insurers believe that the rewards should amount to at least 10 percent of providers’ earnings, but current award levels are typically set between 3 percent and 10 percent.
Rewards are not always financial, particularly among some public insurance P4P initiatives. Nonfinancial incentives include public recognition
Chapter 3: Payments to Providers 103
through distinguished provider ratings, auto-assignment for increased Med- icaid market share, and reduced administrative requirements. Nonfinancial disincentives include practice sanctions, such as nonreferral of patients.
Information Requirements of PqP \ p4P system depends on the collection and reporting of accurate data. For many providers, a substantial capital investment in information technology may be needed for these tasks. Different payers usually have somewhat dif- ferent information and technological requirements for data collection and reporting, although universal standards will eventually apply. These require- ments often involve specification of timeliness and standard data definitions to allow meaningful comparisons across providers. Many P4P systems that use process measures include incentives for expansion of provider informa- tion technology capacity. For example, a P4P program in a large physician practice in California includes a two-part structure measure in calculating performance scores. Points are awarded for clinical patient data integrated at the group level in the first part and for clinical decision support at the point of care in the second part. Clinical decision support tools include telemedi- cine applications and wireless point-of-care e-prescribing.
Beyond the collection and reporting of data, information technol- ogy'' can also facilitate performance improvement that is the focus of a P4P program. For example, some electronic health record software can select individuals from a patient list who are due for a mammogram or who have high blood pressure. Automatic physician notification of these patients can increase the likelihood that they will receive the recommended care. Informa- tion technology also can help providers standardize clinical care and thereby attain better quality scores.
P4P Models in Practice CMS has implemented several P4P demonstration projects intended to test outcomes of particular payment policies to different provider types.
Since 2003, the Premier Hospital Quality Incentive Demonstration has provided financial incentives to 300 participating hospitals for providing quality care in five clinical areas: acute myocardial infarction, coronary artery bypass graft, heart failure, pneumonia, and hip and knee replacement. The program gives rewards based on relative rankings. Providers in the 90th and higher percentiles receive a 2 percent bonus payment on top of standard DRG payments for relevant discharges. The program allocates a 1 percent bonus payment to providers performing in the 80th to 90th percentile range. In the program’s third year, physicians who performed below a set quality threshold were subjected to payment reductions.
Seven private insurers in California have collaborated on a P4P initia- tive for physician group practices called the California Pay for Performance
104 Understanding Healthcare Finance Management
Program. Most health plans follow standards recommended by the Integrated Healthcare Association, which organized the initiative. All performance measurement and reward allocations occur at the physician practice level. Performance is measured in three quality domains: clinical, patient experi- ence, and information technology. Clinical measures include preventive and chronic care processes. Like the CMS demonstration, rewards to physicians are mostly based on relative percentile quality rankings in each domain rather than absolute quality score thresholds. Many of the participating health plans also give rewards for improvement. Actual amounts awarded vary by health plan, but the top-performing groups are usually offered a portion of a maxi- mum PMPM payment. Data are aggregated across health plans, so rankings compare all participating physicians.
In 2005, top-performing physicians in the California Pay for Perfor- mance Program received about $26 million for high scores in the clinical domain, $22 million for patient satisfaction, and $6 million for information technology. The average PMPM amount awarded ranged from $0.05 PMPM to $1.59 PMPM, while the awards to individual physician groups ranged from zero to $4.50 PMPM. Aggregated clinical quality scores improved 5.3 percentage points in the first two years of implementation. Information technology capacity improved most dramatically, with a 54 percentage point increase in the number of medical groups demonstrating some information technology use by the second year.
Bridges to Excellence (BTE) is a third example of a large-scale P4P program. Based on a network of large employers, it incentivizes physicians in three target markets to improve diabetes and cardiac care as well as office systems and care management. Each of three distinct programs—Diabetes Care Link, Cardiac Care Link, and Physician Office Link—identifies a set of recommended measures and assigns a certain number of points to each mea- sure. Physicians who earn a threshold number of points receive a per patient bonus. Top-performing physicians in diabetes and cardiac care earn $200 each. One study based on data from the program found that BTE-recognized physicians performed significandy better than other physicians on cancer and diabetes screening measures.
The Future of P4P As more and more healthcare organizations experiment with different P4P designs, the evidence base for their effect on providers and their quality of care will grow. Some important questions have yet to be answered: What level of financial incentive is needed to change provider behavior? Which combinations of incentive designs and performance measures yield the great- est improvements in a population’s health status? What are the long-term financial implications of financing P4P programs?
Chapter 3: Payments to Providers 105r I
One lesson that resonates across most P4P experience is that provider input and ultimate buy-in are crucial elements of any attempt to improve performance through financial incentives. Providers have a crucial role to play in the discussion and implementation of P4P, and the more effectively they work with insurers, purchasers, and policymakers, the bigger the impact P4P will have.
A P4P Example Perhaps the best way to learn about P4P is by example. In the following sec- tions, we discuss the implementation of P4P across two dimensions (quality and productivity) at one primary care practice.
Fordham Primary Care (FPC) is a medical group practice that employs three primary care physicians who are each paid an annual salary of $200,000. FPC is located in a state that recently announced a new P4P program designed to increase preventive healthcare provided to Medicaid patients. Medicaid patients are a substantial proportion of FPC’s patients, so it decides to participate in the Medicaid P4P program.
Pay for Quality The Medicaid P4P program defines quality performance on the basis of pro- cess measures and allocates rewards on the basis of a benchmark. The process measures are (1) screening mammography for premenopausal women over age 40 who have not been screened within the year, (2) one of five recom- mended colorectal cancer screening options for men over age 50 who are due for screening, and (3) annual influenza vaccinations for all adults over age 50. Rewards are allocated only to physicians who exceed a benchmark of 95 percent on each of the process measures over a six-month period. For example, a physician will receive a reward only if at least 95 percent of her premenopausal women patients over age 40 who have not been screened within the year actually undergo screening mammography. If the benchmark is not achieved, no reward is provided. For physicians who achieve bench- mark performance, Medicaid will pay a bonus of $45 times the actual number of eligible Medicaid patients.
FPC collects the data required for participation in the Medicaid P4P program. The annual results are shown in Exhibit 3.5.
Exhibit 3.5 shows that FPC physicians vary with regard to total number of patients and the percentage of patients who are on Medicaid. Furthermore, not all Medicaid patients are premenopausal women over age 40, men over age 50, or adults over age 50. Thus, only a subset of Medicaid patients count toward P4P rewards; these numbers are shown in the middle section of Exhibit 3.5. The Medicaid quality scores for this subset at the bot- tom of Exhibit 3.5 show that Dr. A met the benchmark of 95 percent on all
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EXHIBIT 3.5
Quality Data for FPC
Dr. A Dr. B Dr.C
Total number of patients: 1,000 1,100 1,200 Percentage who are Medicaid patients 40% 30% 20% Number of Medicaid patients 400 330 240 Possible Number of Medicaid Patients Eligible for P4P Rewards: Breast cancer screening 160 132 96 Colorectal cancer screening 120 99 72 Influenza vaccination 80 66 48
Medicaid Process Measures: Breast cancer screening 99% 95% 95% Colorectal cancer screening 99% 94% 93% Influenza vaccination 98% 95% 94%
three Medicaid process measures. Dr. B met the benchmark for breast cancer screening and influenza vaccination only, and Dr. C met the benchmark for breast cancer screening only.
The next step is to calculate the P4P rewards on the basis of each phy- sician’s quality performance. The results are shown in Exhibit 3.6.
Dr. A met the benchmark for all three Medicaid process measures. Therefore, Dr. A’s pay for quality reward is 160 x $45 = $7,200 for breast cancer screening, 120 x $45 = $5,400 for colorectal cancer screening, and 80 x $45 = $3,600 for influenza vaccination. Dr. B did not meet the benchmark for colorectal cancer screening, so he receives a pay for quality reward for breast cancer screening and influenza vaccination only. Dr. C receives a pay for quality reward for breast cancer screening only.
EXHIBIT 3.6
FPC Physician Pay for Quality
Dr. A Dr. B Dr.C
Bonus per eligible patient $ 45 $ 45 $ 45 Number of Medicaid Patients Who Count Toward P4P Rewards: Breast cancer screening 160 132 96 Colorectal cancer screening 120 0 0 Influenza vaccination 80 66 0
Pay for Quality: Breast cancer screening $ 7,200 $5,940 $4,320 Colorectal cancer screening 5,400 0 0 Influenza vaccination 3,600 2,970 0 Total $16,200 $8,910 $4,320
Chapter 3: Payments to Providers 107
The exhibit shows that the financial effects of the pay-for-quality pro- gram on an individual physician depend on the total number of patients she has, the percentage of these patients who are on Medicaid, the number of these Medicaid patients who count toward the P4P program, and whether she meets the benchmark for each Medicaid process measure. Although Dr. A had the least number of patients, she had the highest percentage of Medicaid patients and was the only physician to meet the benchmark for all three process measures. Consequently, Dr. A receives a total P4P reward of $16,200, the highest among the FPC physicians. Dr. B. had more patients than Dr. A had, but he had a lower percentage of Medicaid patients and met the benchmark for breast cancer screening and influenza vaccination only. Dr. B receives a total P4P reward of $8,910, substantially less than Dr. A’s reward. Dr. C. had more patients than Drs. A and B had, but he had a lower percentage of Medicaid patients and met the benchmark for breast cancer screening only. Dr. C receives a total P4P reward of $4,320.
Pay for Productivity FPC physicians were enthusiastic about implementing a pay-for-quality pro- gram but also concerned that the increased attention to quality may diminish physician productivity. To achieve an appropriate balance of incentives, FPC decided to concurrently implement a pay-for-productivity program. Five per- cent of total salaries (3 physicians x $200,000 per physician x 5% = $30,000) was set aside for productivity pay, to be allocated at the end of the year in proportion to the volume of patient visits.
The data required for the productivity P4P program and the annual results are shown in Exhibit 3.7.
Exhibit 3.7 shows that FPC physicians vary with regard to the total number of patients and the average number of visits per patient. Dr. A has the lowest number of patients but the highest average visits per patient. Dr. A may have a higher proportion of elderly or chronically ill patients who require more visits than do other patients. In contrast, Dr. C has the highest number of patients but the lowest average visits per patient, which may indicate a higher proportion of younger, healthier patients. Dr. B is in between Drs. A and C in both total number of patients and average visits per patient.
Dr. A Dr. B Dr. C Total
Total number of patients 1,000 1,100 1,200 3.300
EXHIBIT 3.7 Productivity
Data for FPC
Average visits per patient 3-0 2.6 2.4 Total number of patient visits 3,000 2,860 2,880 8,740
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EXHIBIT 3.8 FPC
Physician Dr. A Dr. B Dr. C Total
Pay forPercentage of patient visits 34-3% 327% 33.0% 100.0% ProductivityPay for productivity $10,297 $9&7 $9,886 $30,000
The next step is to calculate the P4P rewards on the basis of each physician’s productivity performance. The results are shown in Exhibit 3.8.
Dr. A accounted for 34.3 percent (3,000/8,740) of FPC’s total num- ber of patient visits. Therefore, Dr. A’s pay for productivity reward is 34.3% x $30,000 = $10,297. In comparison to Dr. A., Drs. B and C each accounted for a lower percentage of total number of patient visits and consequently receive a lower pay-for-productivity reward.
Comparison of the Two P4P Programs Exhibit 3.9 shows the combined effect of the pay-for-quality and pay-for- productivity programs on the compensation of each FPC physician.
Dr. A has the highest compensation after participation in P4P, primar- ily because of a substantial pay-for-quality reward. In contrast, Dr. C has the lowest compensation after participation in P4P because of a low pay- for-quality reward. There is little difference between the physicians’ pay-for- productivity rewards. The physicians may all be similarly busy, or perhaps the number of patient visits is not the best measure of productivity.
Both P4P programs demonstrate the challenges of structuring a P4P program that is fair and provides the desired incentives. In the pay-for- quality example, the physicians have an opportunity to earn income in addi- tion to their base compensation of $200,000 by increasing the number of patients who count toward the Medicaid P4P program and by meeting the benchmark for each Medicaid process measure. In the pay-for-productivity example, each physician’s base compensation is essentially reduced by 5% x $200,000 = $10,000, which each can earn back through productivity. If one physician is more productive than her colleagues, she can earn back more than $10,000; if she is less productive, she will earn back less than $10,000.
The source of funds of each P4P program is a key difference. The funds for the Medicaid pay-for-quality program come from a source external
EXHIBIT 3.9 FPC Physician Compensation
Before and After
Participation in P4P
Dr. A Dr. B Dr. C Total
Compensation before P4P $190,000 $190,000 $190,000 $570,000 Pay for quality $ 16,200 $ 8,910 $ 4.320 $ 29,43° Pay for productivity $ 10,297 $ 9.817 $ 9,886 $ 30,000 Compensation after P4P $216,497 $208,727 $204,206 $629,430
Chapter 3: Payments to Providers 109
to the group practice, which increases the practice’s total earnings. The funds for the pay-for-productivity program come from the internal earnings of the group practice. Physicians do not compete for pay-for-quality rewards; if one physician performs particularly well, his reward does not affect the compensa- tion of another physician. However, physicians do essentially compete for pay-for-productivity rewards. If one physician is not as productive as his col- leagues, his compensation will be relatively lower. The different incentives increase the likelihood that physicians will pay more attention to the “rules of the game” of the productivity P4P program.
1. What is the aim of a P4P program designed by an insurer? 2. What are four dimensions of quality that can define performance
in a P4P scheme? 3. What are three ways of allocating P4P rewards? 4. What is the role of information technology in a P4P program? 5. On what lcinds of performance standards are the largest P4P
initiatives basing their awards?
SELF-TEST QUESTIONS
Health Reform and Payments to Providers
In addition to improving healthcare delivery through focusing on access and quality, the ACA has significantly changed the way providers are reimbursed. The key reforms include a move from a fee-for-service model to a prospective payment model, which may include bundled payments or capitation. These new payment methods aim to move reimbursement from one based on vol- ume to one based on value and better outcomes. These payment methods propose to do the following:
• Encourage providers to deliver care in a high-quality, efficient manner • Support coordination of care among multiple providers • Adopt evidence-based care standards and protocols that result in the
best outcomes for patients • Provide accountability and transparency • Discourage overtreatment or medically unnecessary procedures • Eliminate or reduce the occurrence of adverse events • Discourage cost-shifting
The implications of health reform for financial management and health insurance are addressed in chapters 1 and 2, respectively. The implications for payments to providers are discussed here.
110 Understanding Healthcare Finance Management
Value-Based Purchasing Value-based purchasing (VBP) is a CMS initiative that rewards acute care
hospitals with incentive payments for the quality of care they provide to Medicare beneficiaries. VBP is funded by decreasing Medicare reimburse- ments to all hospitals paid under Medicare’s inpatient prospective payment system. Starting in 2013, hospital reimbursements were reduced by 1 per- cent, and the reductions will progressively increase to 2 percent by 2017. The resulting savings fund the incentive program.
VBP aims to promote better clinical outcomes for all hospitalized Medicare patients. To that end, hospitals are encouraged to improve the quality and safety of the care they provide to Medicare beneficiaries as well as other patients during inpatient stays by receiving bonus payments. The amounts of these payments are based on how closely the institution followed best clinical practices, how well it enhanced patients’ care experiences, how well it achieved a quality measure, how much it has improved on each measure compared to its performance during the baseline period, and so on. There is an approved set of performance measures grouped into specific domains. In 2014, hospital performance was measured in the Clinical Process of Care Domain, Patient Experience of Care Domain, and Outcome Domain. In 2015, the Efficiency Domain will be added to these existing domains.
New Models of Bundled Payment Bundled payment models are a form of capitation and an alternative payment
method to the fee-for-service model. Bundled payment is defined as a lump sum payment that covers all healthcare services related to a specific proce- dure. The objective of bundled payments is to promote more efficient use of resources and reward providers for improving the coordination, quality, and efficiency of care. If the cost of services is less than the bundled payment, the physicians and other providers retain the difference. But if the costs exceed the bundled payment, physicians and other providers are not compensated for the difference.
In terms of payment, in some circumstances one entity—an ACO— may receive the bundled payment and subsequently divide the payment among participating physicians and providers. In another situation, the payer may pay the participating physicians and providers independently, but it may adjust each payment according to negotiated predefined rules to ensure that the total payments to all the providers do not exceed the total bundled payment amount. This type of payment method is called virtual bundling. Challenges of bundled payments include determining who owns the episode of care and the portioning of the payment between the various providers.
Chapter 3: Payments to Providers 111
Shared Savings Shared savings is an approach to reducing healthcare costs and has been pro- posed as a mechanism for encouraging the creation of ACOs. Under shared savings, if a healthcare organization or provider reduces total healthcare spending for its patients below the level that the payer expected, the provider is then rewarded with a portion of the savings. The benefits are twofold: (1) the payer spends less than it would otherwise, and (2) the provider gets more revenue than it expected. The savings can arise from more efficient, cost- effective use of hospital or outpatient services that enhance quality, reduce costs over time, and improve outcomes. It can be applied to hospital episodes of care, including physician services, or to physician office care.
Quality-Based Clinician Compensation The ACA requires Medicare to factor quality into payments for physicians and most clinicians. Quality-based compensation is part of Medicare’s effort to shift medicine away from the volume-based focus, where clinicians are paid for each service regardless of the quality. Quality-based compensation links clinician pay with quality outcomes. Clinicians can earn additional compensa- tion based on the quality and cost-effectiveness of the care they provide to their patients. Bonuses and penalties are calculated on the basis of perfor- mance on quality measures, which vary from speciality to specialty.
Other Models A number of changes to payments are being implemented as part of the ACA. They are discussed below.
Disproportionate Share Hospital Payments Hospitals treating large numbers of low-income patients receive dispropor- tionate share hospital (DSH) payments to cover the costs of providing care to uninsured patients. Based on the assumption of increased coverage and decreased uncompensated care costs, resulting from the ACA, DSH pay- ments are expected to decline. Annual reductions (by 25 percent initially) in DSH payments started in 2014 and will last through 2020.
Direct Graduate Medical Education New graduates from medical school continue their medical training as resi- dents in teaching hospitals. Medicare is the primary source of funding for graduate medical education, which covers the costs directly and indirectly related to educating residents. These funds cover resident salaries and ben- efits, faculty salaries and benefits, administrative overhead expenses, and the cost of higher patient care due to sicker patients. The Medicare budget for
112 Understanding Healthcare Finance Management
fiscal year 2014 proposed a reduction in graduate medical education funding by 10 percent, which would result in approximately $11 billion in savings over ten years.
Readmission Reduction Program With the passage of the ACA, CMS now has the authority to penalize hospi- tals if they experience excess readmission rates compared to expected levels of readmission. The readmissions are based on a 30-day readmission measure for heart attack, heart failure, and pneumonia. The payment reductions started in federal fiscal year 2013, with a 1 percent cut in all inpatient Medicare pay- ments. The reduction increased to 2 percent in 2014 and 3 percent in 2015.
Hospital-Acquired Conditions Starting in 2015, hospitals will be penalized by Medicare for hospital- acquired conditions. Hospital-acquired conditions include bedsores, compli- cations from extended use of catheters, and injuries caused by falls. Hospitals will face a 1 percent reduction in Medicare inpatient payments for all dis- charges if the hospital ranks in the top 25 percent of hospital-acquired condi- tions for all hospitals in the previous year.
SELF-TEST QUESTION 1. Briefly describe the impact of the ACA on payments to providers.
Chapter Key Concepts Reimbursement methods, risk sharing, and pay-for-performance have a profound influence on the risk and behavior of providers. In this chapter, some of the more important aspects of these topics are discussed. Here are its key concepts:
• When payers pay billed charges, they pay according to the schedule of charge rates established by the provider.
• Negotiated charges, which are discounted from billed charges, are often used by insurers in conjunction with managed care plans such as HMOs and PPOs.
• Under a retrospective system, the payer agrees to pay the provider certain allowable costs expected to be incurred in providing services to the payer’s enrollees.
• In a prospective payment system, the rates paid by payers are determined in advance and are not tied directly to reimbursable
Chapter 3: Payments to Providers 113
costs or billed charges. Typically, prospective payments are made on the basis of the following service definitions: (1) per procedure, (2) per diagnosis, (3) per diem (per day), or (4) bundled (global) pricing.
• Capitation is a flat periodic payment to a physician or other healthcare provider; it is the sole reimbursement for providing services to a defined population. Capitation payments are generally expressed as some dollar amount per member per month (PMPM). In this term, the word member typically means an enrollee in some managed care plan—usually an HMO.
• Under fee-for-service, all volumes less than breakeven produce a loss for the provider, while all volumes greater than breakeven produce a profit. Under capitation, all volumes less than breakeven produce a profit, whereas all volumes greater than breakeven produce a loss. Thus, provider incentives under capitation are opposite those under conventional reimbursement.
• In 1983, the federal government adopted the inpatient prospective payment system (IPPS) for Medicare hospital inpatient reimbursement. Under IPPS, the amount of the payment is fixed by the patient’s Medicare severity diagnosis-related group (MS-DRG).
• To provide some cushion for the high costs associated with severely ill patients within each diagnosis, IPPS includes a provision for outlier payments.
• In 2000, Medicare reimbursement for hospital-based outpatient care was changed from a cost-based system to the outpatient prospective payment system (OPPS). The payment calculation is similar to that for inpatient care. Also, Medicare recently created prospective payment systems for nursing home and home health care services that are much less generous than the previous cost- based systems.
• Physicians are reimbursed by Medicare through the resource-based relative value system (RBRVS). Under RBRVS, reimbursement is based on three resource components: (1) physician work, (2)
practice expenses, and (3) malpractice insurance. Each of these components is given a weighting for each of approximately 7,500 procedures. The weightings are summed and multiplied by a dollar conversion factor to determine the payment amount.
(continued)
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• Pay-for-performance (P4P) plans use provider payments to incentivize certain behaviors. They usually encourage quality improvement but can be used to motivate physicians to increase productivity or financial contribution to a group practice. P4P programs used in practice vary widely in intent and design.
• Outcome, process, patient satisfaction, and structure are four dimensions of quality measured by P4P programs.
• Financial rewards are given to providers who meet predefined relative, benchmark, or improvement standards, depending on how the P4P program is designed. Dollar amounts provided by P4P plans also vary.
• The ACA has significantly changed the way providers are reimbursed. The new payment methods emphasize value and better patient outcomes over volume.
This concludes our discussion of reimbursement methods, risk sharing, and pay for performance.
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and that tests
your ability to perform the calculations in preparation for a case
These resources can be accessed on the book’s companion website at ache .org/books/UHFM7.
Selected Case
One case in Cases in Healthcare Finance, 5th edition, is applicable to this chapter:
• Case 11: Orlando Family Physicians, which focuses on implementation of a pay-for-performance program by a medical group practice
Chapter 3: Payments to Providers 115
Selected Bibliography
n T 2013. “Bundled Payment: Hospitals See the Advantages, But Face Big
Challenges Too.” Hospital & Health Networks 87 (4): 26-31.
gijkenaar, F., M. Emmert, M. Scheppach, and O. Schoffski. 2013. “Effects of Pay
for Performance in Health Care: A Systematic Review of Systematic Reviews.”
Health Policy 110 (2): 115-130.
Foster, D., and G. Harkness. 2010. “Healthcare Reform: Pending Changes to
Reimbursement for 30-day Readmissions.” Posted August,
www.communitysolutions.com/assets/2012_Institute_Presentations/acareimbuesement
changes051812 .pdf.
Frakt, A. B., and R. Mayes. 2012. “Beyond Capitation: How New Payment Experi-
ments Seek to Find the ‘Sweet Spot’ in Amount of Risk Providers and Payers
Bear.” Health Affairs 31 (9): 1951-958.
Harris, J., I- Elizondo, and A. Isdaner. 2014. “Medicare Bundled Payment: What Is
It Worth to You?” Healthcare Financial Management 68 (1): 76-82.
Hsieh, H. M., and G. J. Bazzoli. 2012. “Medicaid Disproportionate Share Hospi-
tal Payment: How Does It Impact Hospitals’ Provision of Uncompensated
Care?” Inquiry 49 (3): 254—67.
McClellan, M. 2011. “Reforming Payments to Healthcare Providers: The Key to
Slowing Healthcare Cost Growth While Improving Quality?” Journal of Eco-
nomic Perspectives 25 (2): 69-92.
Mehrotra, A., C. L. Damberg, M. E. Sorbero, and S. S. Teleki. 2009. “Pay for Perfor-
mance in the Hospital Setting: What Is the State of the Evidence?” American
Journal of Medical Quality 24 (1): 19-28.
Muhlestein, D. B., A. A. Croshaw, and T. P. Merrill. 2013. “Risk Bearing and Use of
Fee-for-Service Billing Among Accountable Care Organizations.” American
Journal of Managed Care 19 (7): 589-92.
Ryan, A. M. 2009. “Effects of the Premier Hospital Quality Incentive Demonstra-
tion on Medicare Patient Mortality and Cost.” Health Services Research 44
(3): 821-42.
Siddiqui, M., and S. A. Berkowitz. 2013. “Shared Savings Models for ACOs—Incen-
tivizing Primary Care Physicians.” Journal of General Internal Medicine 29
(6): 832-34.
VanLare, J. M., and P. H. Conway. 2012. “Value-Based Purchasing—National Pro-
grams to Move from Volume to Value.” New England Journal of Medicine
367 (4): 292-95.
Weissman, J. S., M. Bailit, G. D’Andrea, and M. B. Rosenthal. 2012. “The Design
and Application of Shared Savings Programs: Lessons from Early Adopters.”
Health Affairs 31 (9): 1959-968.
Understanding Healthcare Finance Management
Selected Websites
• For more information on California’s physician pay-for-performance initiative, visit the IHA website at www.iha.org.
• Bridges to Excellence has an informative website that provides further details on its P4P programs; see wwwcbridgestoexcellence.org.
• To read more about hospital P4P, see the web pages devoted to the topic on the CMS site at www.cms.hhs.gov/HospitalQualityInits/35_ hospitalpremier.asp.
• Other information can be found on the Premier website at www. premierinc.com/quality-safety/tools-services/p4p/hqi/index.jsp.
• To read more about payment reform, see the website of the Center for Healthcare Quality and Payment Reform at www.chqpr.org.
Note
1. Our purpose here is not to make you an expert in Medicare’s payment methods. Most healthcare organizations, other than the smallest, have one or more specialists on the financial staff whose sole responsibility is to keep track of changes in Medicare reimbursement practices. However, Medicare payment systems are used by many payers for many different types of providers, so all healthcare managers should have some knowledge of these systems. For excellent summaries of the payment systems used by CMS, see “Payment Basics” (www.medpac. gov/-documents-/payment-basics) published by MedPAC.
CHAPTER SUPPLEMENT
RISK SHARING UNDER CAPITATION
Supplement Learning Objectives After studying this chapter supplement, readers should be able to
• explain the risk-sharing process, including its goals and implementation problems.
The Need for Risk Sharing
In an integrated delivery system, or within the provider panel of a managed care plan, different providers are brought together in some type of formal or informal arrangement to provide healthcare services to a defined population.
When all system participants receive capitated payments, conflicts may occur between primary care physicians and specialists and institutions. Primary care physicians benefit financially from referring care to a special- ist rather than providing that care because their costs are reduced but their revenues remain unchanged. Specialists, who also receive capitated payments, may not welcome the added volume because it increases their costs and does not increase their revenues. A similar dynamic exists between primary care doctors and hospitals.
In such situations, risk-sharing arrangements are sometimes imple- mented to encourage providers to act in the best interest of the system rather than self-interest. Proper incentives for provider panels are created by establishing withholds, or risk pools, which are pools of money that are initially withheld and then distributed to panel members if they meet certain pre- established goals.
Risk-sharing arrangements typically allocate 10 percent to 20 percent of each reimbursement dollar to one or more risk pools—often for primary, specialty (referral), and institutional care. Throughout the year, expenses are charged against the applicable pools, and at year-end, each pool’s expenses are compared with those budgeted. Any surpluses are distributed to the par- ticipating providers on the basis of a prearranged formula, while any deficits typically are funded from network reserves.
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Risk pools can be used with any type of reimbursement system. When used with a per diem system, the hospital is rewarded if utilization, as mea- sured by patient days, is less than expected. If utilization exceeds the target the hospital is penalized; either a portion or the entire amount of its reward is withheld. Risk pools are designed to reward providers that are most able to control costs through better utilization management, better cost control, or both. Risk-sharing arrangements can be made among physicians only, among physicians and hospitals, or among all providers. Furthermore, risk pools can be established to promote only financial goals or some combination of finan- cial and nonfinancial goals, such as higher quality.
Note that if a system is fully integrated and all subsidiary providers are owned by—and hence directly responsible to—the same parent, there is only one bottom line and no need for risk-sharing arrangements. Proper incen- tives are created by managerial control. However, in most systems today, providers are loosely affiliated rather than members of the same business entity, so risk-sharing arrangements are needed to align the incentives of the diverse parties involved.
Primary Care Withhold: Single Risk Pool
The best way to grasp the basics of risk sharing is through examples. In this section, we illustrate a withhold system for primary care physicians only. In the next section, we illustrate a risk-sharing system that encompasses primary care physicians, specialists, and a hospital.
In the risk-pool arrangement for primary care physicians (PCPs) used by one HMO, the HMO pays its PCPs by capitation, but a percentage of the total capitated amount is held in reserve and distributed to individual physicians if certain financial goals are met. In general, PCP goals are based on specialty care and hospital costs. The goal is to lower the overall cost of providing care, but cost-reduction goals should not reduce the quality of care afforded to patients.
Assume that the HMO’s capitation payment to PCPs is $15 PMPM but that 20 percent of this amount is placed in the PCP risk pool. The bud- geted amount for specialty and hospital costs is $45 PMPM. The purpose of the pool is to encourage PCPs to take actions that cause realized specialty and hospital costs to be less than those budgeted. For simplicity, assume that there are three PCPs in the plan: (1) Physician L (for low cost), (2) Physician M (for medium cost), and (3) Physician H (for high cost). In this example, cost is measured by the amount the HMO spends on each physician’s refer- rals. Furthermore, assume that each physician has 1,000 patients under the plan, so there are 3,000 patients in total.
r Chapter 3 Supplement: Risk Sharing Under Capitation 119Exhibit S3.1 contains the risk-pool distributions for two different out-come scenarios. Line 1 shows each PCP’s initial annual capitation payment:$15 PMPM x 12 months x 1,000 members = $180,000. Thus, 3 x $180,000= $540,000 in total is allocated for PCP payments. However, 20 percent of the capitated amount is placed in the risk pool, so each PCP’s annual capi- tated payment is reduced by 0.20 x $180,000 = $36,000. This reduction and the resulting $144,000 initial allocation are shown in lines 2 and 3. Note that each of the members served by the three PCPs is allocated $45 for specialty and hospital costs, so the budgeted goal for these costs is 1,000 x $45 x 12 = $540,000 per PCP, or $1,620,000 in total, as shown in line 4. Also note that the total amount in the PCP risk pool is 3 x $36,000 = $108,000.
r
Now consider scenario 1, contained in lines 5, 6, 7, and 8. Here, the assumption is that no PCP will receive any funds from the pool if it is empty at year-end. The actual referral costs for each PCP are the amounts shown in line 5. The referral gain (loss) for each PCP is shown in line 6, while the total gain (loss) for all three PCPs is $40,000 - $20,000 - $140,000 = -$120,000. This amount exceeds the $108,000 in the risk pool, so no funds remain for distribution. In fact, the HMO will have to fund the $108,000 - $120,000 = $12,000 shortfall with its own reserves. Because no funds remain in the pool for distribution, each
C hapter 3 Supplem
ent
PCP’s realized compensation would be her initial allocation—$144,000. Clearly, there is a problem with the way the risk pool is allocated.
Because no funds remained in the pool, all three PCPs were equally penalized, even though Physician L did an excellent job of controlling referral costs and Physician M came in only $20,000 over budget. The real cause of the failure
EXHIBIT S3.1 Physician L Physician M Physician H Primary Care
1.Allocated amount $180,000 $180,000 $180,000 Physician 2.Withhold (20 percent) (36,000) (36,000) (36,000) (PCP) Risk 3-Initial allocation $144,000 $144,000 $144,000 Pool (Annual 4-Budgeted referral costs $540,000 $540,000 $540,000 Amounts)
Scenario 1: Distribution Based on Aggregate PCP Performance 5. Actual referral costs 500,000 560,000 680,000 6. Referral gain (loss) $ 40,000 ($ 20,000) ($140,000) 7. Withhold returned 0 0 0 8. Total compensation $144,000 $144,000 $144,000
Scenario 2: Distribution Based on Individual PCP Performance 9- Actual referral costs 500,000 560,000 680,000 10. Referral gain (loss) $ 40,000 ($ 20,000) ($140,000) 11. Withhold returned 36,000 16,000 0 12. Total compensation $180,000 $160,000 $144,000
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to meet the overall referral budget was Physician H, who was a whoppjng $140,000 over budget. Is it fair to penalize L and M because of H’s actions- If, over time, it appears to Physicians L and M that the risk pool will always be exhausted as a result of actions beyond their control, they will have no motiva- tion to continue to practice as efficiently as they do now. Also, it is important to know whether Physician H’s failure to meet the risk-pool budget was a result of practice patterns or due to an extraordinary number of high-cost patients. If the patient mix is not equal across PCPs, obvious problems will arise, so when assigning patients, the HMO must be careful to ensure, to the extent possible, that the utilization and intensity mix is evenly spread across PCPs or that adjustments are made to account for such differences.
Scenario 2 in Exhibit S3.1 is similar to scenario 1, except that pay- ments are made from the withhold to individual physicians regardless of the aggregate position of the pool. In this situation, the aggregate pool is artificial. Because the HMO will reward individual PCPs who come in at or under budget regardless of aggregate performance, each PCP really has his own individual risk pool. Thus, as shown in line 11, Physician L, because he came in below budget, received the entire withhold amount from his pool, for a total compensation of $144,000 + $36,000 = $180,000. Physician M received $36,000 - $20,000 = $16,000 from her pool, for a total compensa- tion of $160,000. Physician H, on the other hand, received nothing from her pool, for a total compensation of $144,000. This type of arrangement creates better incentives for PCPs, but the HMO had to bear the total cost of the pool payments—$52,000—because the actions of Physician H depleted the pool. The key here is to modify the behavior of Physician H so that funds remain in the pool to make the incentive payments. Perhaps, after one year, Physician H will be motivated to follow lower-cost practice patterns because of the potential monetary reward.
Note that there are numerous ways in which a PCP risk pool can be distributed. Here is another alternative to scenario 2: If the aggregate risk pool is depleted, payments to individual physicians will be cut in half. If this situation were the case in scenario 2 in Exhibit S3.1, Physician L would receive only $18,000 from the pool in line 12, while Physician M would be paid $8,000. Now the actions of Physician H have a direct bearing on the payments to L and M, so it is in the best interests of L, M, and the system to encourage H to lower costs. Also, in this distribution system, the HMO does not replace the full amount of the pool if it is depleted.
Primary Care and Referral Withholds: Two Risk Pools
The previous illustration placed only one set of providers at risk—the PCPs. In this section, we illustrate the use of two risk pools.
r Chapter 3 Supplement: Risk Sharing Under Capitation 121Assume that HealthyHMO, with 10,000 covered lives in a given ser-vice area, reimburses its PCPs via a capitated system, its specialty care physi- cians via a discounted fee-for-service system, and the hospital via a per diem system. To create incentives, HealthyHMO establishes two risk pools: (1) a professional services risk pool for the physicians only and (2) an inpatient services risk pool shared equally by the HMO, physicians, and hospital.
Professional Services Risk Pool Ten percent of the funds budgeted for specialty services are withheld in the professional services risk pool (PSRP). The total amount budgeted for professional services, including primary and specialty care physicians, is $37 PMPM. With 10,000 members, the HMO’s annual budget for professional services is $37 x 10,000 x 12 = $4,440,000.
The capitated payment for PCPs is $12 PMPM, for a total of $12 x 10,000 x 12 = $1,440,000. The difference between the total allocated for professional services and the capitated total for primary care services is $4,440,000 - $1,440,000 = $3,000,000, which is the amount allocated for specialty services. Because 10 percent of the specialists’ budget is placed in the PSRP, it is funded at a level of $300,000, and the budget for specialist payments, after withhold, is $2,700,000.
When the budget year is over, a year-end reconciliation process adjusts for underutilization and overutilization and allocates the pool among the PCPs and specialist physicians. If actual costs exceed the $3 million total specialty care budget, no distributions are made from the PSRP, and HealthyHMO must cover the shortfall. Exhibit S3.2 illustrates end-of-year reconciliation for four different scenarios. In scenario 1, actual payments for specialty services are assumed to be $3 million, as shown in line 2. The result is a -$300,000 variance from the after-with hold budget, and the risk pool is depleted. The PCPs gain no additional income because the specialists’ fee- for-service payments have used up the entire amount in the pool.
Specialist payments in scenario 2 are $3.1 million and cause a -$400,000 budget variance. As in scenario 1, nothing is left for the primary care physicians. In fact, the specialists have not only exhausted the pool but also received $100,000 in additional payments from HealthyHMO, which must bear all losses exceeding the amount placed in the pool.
Scenario 3, which begins at line 13 in Exhibit S3.2, presents a lower- cost situation in which specialty care payments are only $2.8 million. Now, the budget variance is -$100,000, which leaves $200,000 in the pool for distribu- tion. Many methodologies can be used to make the distribution. For example, the $200,000 can be evenly split among all physicians. Alternatively, the pool can be distributed to the physicians on a basis proportional to the amount of effort they expend on HealthyHMO’s patients, measured by the number of patient visits or the dollar amount paid to each physician, for example.
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122 Understanding Healthcare Finance Management
EXHIBIT S3.2 ------ --
ProfessionalScenario 1: Specialty Payments of $3,000,000 Services Risk 1. Budgeted payments for specialty services $2,700,000 Pool (PSRP) 2. Actual payments for specialty services 3.000,000
(Annual 3. Variance from budget ($ 300,000) Amounts) 4. Risk pool starting amount 300,000
5. Remainder in pool $ 0 6. Risk pool allocation $ 0
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t Scenario 2: Specialty Payments of $3,100,000 7. Budgeted payments for specialty services $2,700,000 8. Actual payments for specialty services 3,100,000
9. Variance from budget ($ 400,000) 10. Risk pool starting amount 300,000 11. Remainder in pool ($ 100,000) 12. Risk pool allocation $ 0
Scenario 3: Specialty Payments of $2,800,000 13. Budgeted payments for specialty services $2,700,000 14. Actual payments for specialty services 2,800,000 15. Variance from budget ($ 100,000) 16. Risk pool starting amount 300,000 17. Remainder in pool $ 200,000 18. Risk pool allocation $ 200,000
Scenario 4: Specialty Payments of $2,600,000 19. Budgeted payments for specialty services $2,700,000 20. Actual payments for specialty services 2,600,000 21. Variance from budget $ 100,000 22. Risk pool starting amount 300,000 23. Remainder in pool $ 400,000 24. Risk pool allocation
a. Physicians $ 300,000 b. HMO 100,000
Scenario 4 is similar to scenario 3, except that with only $2.6 mil- lion paid to specialists over the year, the pool is left with $400,000. Now, $300,000 is available for distribution to physicians, and $100,000 is reclaimed by HealthyHMO.
Inpatient Services Risk Pool HealthyHMO budgets for the inpatient services risk pool (ISRP) on the basis of 350 inpatient days per 1,000 members, which is the rate the HMO
r
Chapter 3 Supplement: Risk Sharing Under Capitation 123
experienced last year for its entire membership. The negotiated per diem rate is $750. Thus, its 10,000 members are expected to use 10 x 350 = 3,500 inpatient days, which means a before-withhold amount of 3,500 x $750 = $2,625,000. HealthyHMO withholds 10 percent of the inpatient budget for the ISRP—that is, $262,500. Thus, the adjusted per diem rate is 0.90 x $750 = $675, for a total budgeted payment for inpatient services of 3,500 x $675 = $2,362,500.
For reconciliation purposes, suppose that actual utilization was 385 inpatient days versus the 350 forecast (10 percent variance higher than forecasted). The resulting ISRP distribution is shown in Exhibit S3.3. With overutilization (as compared to the budget), realized payments total 3,850 x $675 = $2,598,750 (as shown in line 2), causing a dollar variance of -$236,250 (as shown in line 3). Because the pool was initially funded with $262,500, the amount left in the pool after reconciliation is $262,500 - $236,250 = $26,250, which is shown in line 5. This amount, according to distribution guidelines, is split evenly among PCPs, specialty care physicians, and the hospital (as shown in lines 6a through 6c).
Note that the hospital’s per diem payment before withhold was $750. After reconciliation, the hospital’s total payment is $2,598,750 + $8,750 = $2,607,500. Because this total resulted from 3,850 inpatient days, the real- ized per diem payment was $2,607,500/3,850 = $677. This amount is less than the starting $750 amount because more than the budgeted amount was spent on inpatient care. However, because some funds remained in the pool, the final per diem amount is slightly more than the $675 after-withhold amount. Even if less than the budgeted amount is spent on inpatient care, the hospital still will receive less than the initial $750 per diem amount because any savings will be split three ways.
The intent of the ISRP is to encourage the parties that have some control over hospital utilization to limit the number of inpatient days to those that are absolutely essential to patients’ welfare. Because the hospital is reimbursed on a per diem basis, it has an incentive to maximize the number of inpatient days. Any gain from additional per diem payments will be three
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i- Budgeted payments for inpatient services 2. Actual payments for inpatient services 3- Variance from budget 4- Risk pool starting amount 5- Remainder in pool 6. Risk pool allocation
Specialty care physicians (1/3)
$2,362,500 2,598,750
($ 236,250) 262,500
$ 26,250
EXHIBIT S3.3
Inpatient Services Risk Pool (ISRP) (Annual Amounts)
a- Hospital (1/3) b. Primary care physicians (1/3)
7- Total allocated
$ 8,750 8,750 8,750
$ 26,250
124 Understanding Healthcare Finance Management
times as profitable as pool distributions because per diem payments are not shared with physicians. Therefore, the ISRP is really set up to motivate physi- cians, who actually control hospital admissions and discharges. Under per diem, the hospital does have an incentive to lower costs because lower costs lead to higher profits. However, the best way to motivate the hospital to control utilization would be to change its payment system to capitation.
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SELF-TEST QUESTIONS
Supplement Case
One case in Cases in Healthcare Finance, 5th edition, is applicable to this chapter supplement:
• Case 32: Santa Fe Healthcare, which focuses on reimbursement and risk-sharing plans
BASIC FINANCIAL MANAGEMENT CONCEPTS
Before we discuss the details of the financial management of healthcareorganizations, we must first explain two fundamental topics that areimportant for you to learn. Most financial management decisions involve future dollar amounts.
For example, when a physician group practice uses debt financing, it is obligated to make a series of future (principal and interest) payments to the lender. Or, when a hospital builds an outpatient surgery center, it expects the investment to provide a series of future cash flows when it is “up and run- ning.” To estimate the financial impact of these transactions, the organization must value future dollar amounts. This valuation is called time value analysis. Chapter 4 provides the concepts necessary to perform this analysis.
Chapter 5 discusses financial risk and required return. Virtually all financial decisions involve risk. For example, a physician group practice that obtains debt financing risks not being able to make the required payments. Or, a hospital that builds a new outpatient surgery center is at risk that the center will take in less cash flow than that forecasted when the center was built. Such situations involve financial risk, and to make good financial deci- sions, managers must be able to define and measure this risk. Furthermore, risk must be translated into required rates of return. For example, to be finan- cially attractive, the new outpatient surgery center must provide an expected rate of return that is sufficient to compensate the hospital for the riskiness of its investment. Chapter 5 provides the tools required to perform this task.
CHAPTER
TIME VALUE ANALYSIS 4 Learning Objectives After studying this chapter, readers should be able to
• explain why time value analysis is important to healthcare financial management;
• find the present and future values for lump sums, annuities, and uneven cash flow streams;
• apply the opportunity cost principle; • measure the return on an investment; • create an amortization table; and • apply stated, periodic, and effective annual interest rates.
Introduction
The financial value of any asset—whether a financial asset (such as a stock or a bond) or a real asset (such as a piece of diagnostic equipment or an ambula- tory surgery center)—is based on future cash flows. However, a dollar to be received in the future is worth less than a current dollar because a dollar in hand today can be invested, earn interest, and hence be worth more than one dollar in the future. If no investment opportunities existed, a dollar in hand would still be worth more than a dollar to be received in the future because a dollar today can be used for immediate consumption, whereas a future dollar cannot. Because current dollars are worth more than future dollars, valuation analyses must account for cash flow timing differences.
The process of assigning appropriate values to cash flows that occur at different points in time is called time value analysis. However, the applica- tion of time value analysis to valuation situations is often called discounted cash flow analysis because, as you will see later in this chapter, finding present values is called discounting. Time value analysis is an important part of many healthcare financial management decisions because many financial analyses involve the valuation of future cash flows. Of all the financial analysis tech- niques discussed in this text, none is more important than time value analy- sis. The concepts presented in this chapter are the cornerstones of financial analysis, so a thorough understanding of these concepts is essential to good financial decision making.
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128 Understanding Healthcare Finance Management
Time Lines
One important tool used in time value analysis is the time line. Time lines make it easier to visualize when the cash flows in a particular analysis occur For an illustration of the time-line concept, consider the following five-period time line:
Time 0 is any starting point; Time 1 is one period from the start- ing point, or the end of Period 1; Time 2 is two periods from the starting point, or the end of Period 2; and so on. Thus, the numbers above the tick marks represent ends of periods. Often, the periods are years, but other time intervals—such as quarters, months, or days—are also used when needed to fit the timing of the cash flows being evaluated. If the periods are years, the interval from 0 to 1 would be Year 1, and the tick mark labeled 1 would represent both the end of Year 1 and the beginning of Year 2. In many time value analyses, Time 0 (the starting point) is considered to be today, although the term today usually does not literally mean today’s date. Rather, Time 0 typically identifies the start of the analysis, which begins when the first cash flow occurs.
Cash flows are shown on a time line directly below the tick marks, at the point they are expected to occur. The interest rate relevant to the analysis is sometimes shown directly above the time line in the first period. (In rare cases, it may be appropriate to apply more than one interest rate in a time value analysis. In this situation, interest rates may be shown in multiple peri- ods.) Additionally, unknown cash flows—the ones to be determined in the analysis—are sometimes indicated by question marks. Here is an example of a completed time line:
-$ioo ?
Here, the interest rate for each of the three periods is 5 percent, a lump sum (single amount) investment of $100 is made at Time 0, and the Time 3 value is to be determined. The $100 is an outflow because it is shown as a negative cash flow. (Outflows are often designated by parentheses rather than by minus signs.) In simple analyses, it is not necessary to designate cash flows as inflows and outflows because the analyst is well aware of the economics
Chapter 4: Time Value Analysis 129
of the situation. However, more complicated analyses require the correct cash flow designation, and many financial calculators require that signs be attached to cash flows in all analyses, even simple ones. Thus, to ensure you are familiar with sign conventions, we use them in most of our illustrations.
Time lines are essential when learning time value concepts, but even experienced analysts use time lines when dealing with complex problems. The time line may be an actual line, as used in this chapter, or it may be a series of columns, or rows, on a spreadsheet. Time lines will be used extensively in the remainder of this text, so get into the habit of creating time lines when conducting time value analyses.
1. Draw a three-year time line that illustrates the following situation: an investment of $10,000 at Time 0; inflows of $5,000 at the end of Years 1,2, and 3; and an interest rate of 10 percent during the entire three-year period.
SELF-TEST QUESTION
Future Value of a Lump Sum (Compounding)
The process of going from today’s values, or present values (Pvs), to future values is called compounding. Although compounding is not used extensively in healthcare financial management, it is the best point from which to start learning time value concepts. For an example of lump-sum compounding, which deals with a single starting dollar amount, suppose that the manager of Meridian Clinic deposits $100 of the clinic’s excess cash in a bank account that pays 5 percent interest per year. How much would be in the account at the end of one year?
Before you begin, you need to understand the terms used in the solution:
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• Pv = $100 = present value, or beginning amount, of the account. • I = 5% = interest rate the bank pays on the account per year. The
interest amount, which is paid at the end of each year, is based on the balance at the beginning of the year. Expressed as a decimal, I = 0.05.
• INT = dollars of interest earned each year, which equals the beginning amount multiplied by the interest rate. Thus, for Year 1, INT = Pv x I.
• FVN = future value, or ending amount, of the account at the end of N years. Whereas Pv is the value now and FvN is the value N years into the future, after the interest earned has been added to the account.
• N = number of years (or periods) involved in the analysis.
130 Understanding Healthcare Finance Management
If N = 1, FVN is calculated as follows:
Fv, = Fv, = Pv + INT
= Pv + (Pv X I)
= Pv X (1 +1).
The future value at the end of one year, Fvp equals the present value multiplied by (1 plus the interest rate). This future value relationship can be used to find how much $100 will be worth at the end of one year if it is invested in an account that pays 5 percent interest:
Fvj = Pv x (1 + I) = $100 x (1 + 0.05) = $100 x 1.05 = $105.
Now, what would be the value after five years? Here is a time line that shows the amount at the end of each year:
Beginning amount -$ioo
Interest earned
End-of-year amount
Note the following points:
• The account is opened with a deposit of $100. This deposit is shown as an outflow at Year 0. It is an outflow to Meridian because Meridian is depositing the funds with the bank as opposed to receiving the funds from the bank, which would be an inflow.
• Meridian earns $100 x 0.05 = $5 of interest during the first year, so the amount in the account at the end of Year 1 is $100 + $5 = $105.
• At the start of the second year, the account balance is $105. Interest of $105 x0.05 = $5.2 5 is earned on the now larger amount, and the account balance at the end of the second year is $105 + $5.25 = $110.25. The Year 2 interest, $5.25, is higher than the first year’s interest, $5, because $5 x 0.05 = $0.25 in interest was earned on the first year’s interest.
• This process continues, and because the beginning balance is higher in each succeeding year, the interest earned increases in each year.
• The total interest earned, $27.63, is reflected in the balance at the end of Year 5, $127.63.
Chapter 4: Time Value Analysis 131
To better understand the mathematics of compounding, note that the Year 2 value—$110.25—is calculated as follows:
FV2 = Fv1 x (1 + I) = Pvx(l + I)x(l + I)
= Pvx(l +I)2
= $100 x (1.05)2 = $110.25.
Furthermore, the balance at the end of Year 3 is
FV3 = FV2 x (1 + I)
= Pv X (1 + I)3
= $100 X (1.05)3 = $115.76.
If we continue the calculation to the end of Year 5, we get
FV5 = $100 x (1.05)5 = $127.63.
A pattern exists in these future value calculations. In general, the future value of a lump sum at the end of N years can be found by applying this equation:
Key Equation 4.1: Future Value of a Lump Sum
FvN = Pv x (1 + I)N.
Future values, and most other time values, can be calculated three ways: (1) by using a regular calculator, (2) by using a financial calculator, and (3) by using a spreadsheet.1 This textbook focuses on the spreadsheet solution technique, but we also illustrate the use of regular calculators to help you understand the setup of the problem and the underlying time value calculation. (If you are using a financial calculator for time value analyses, visit this book’s companion website at ache.org/books/UHFM7. The site has a financial calculator tutorial that covers most of the calculations in this chapter.)
Regular Calculator Solution A regular (nonfinancial) calculator can be used, either by multiplying the Pv by (1 + I) for N times or by using the exponential function to raise (1 + I) to the Nth power and then multiplying the result by the Pv. The easiest way to find the future value of $100 after five years when compounded at 5 percent is to enter $100 and then multiply this amount by 1.05 five times. If the calculator is set to display two decimal places, the answer is $127.63:
132 Understanding Healthcare Finance Management
2 3 J L
l
x 1.05 x 1.05 = $127.63
4 5 J I
As denoted by the arrows, compounding involves moving to the right along the time line. The word compounding means to add to or increase, so values increase when moving to the right along a time line.
Spreadsheet Solution
A B C D
1 2 5 Nper Number of periods
3 $100.00 Pv Present value 4 5.0% Rate Interest rate 5 6 $127.63 = IOO*(I.O5)A5 (entered into cell A6)
7 8 $127.63 =A3*(I+A4)AA2 (entered into cell A8)
9 10 $127.63 =FV(A4,A2„-A3) (entered into cell A10)
Spreadsheet programs, such as Excel, are ideally suited for time value analyses. For simple time value calculations, it is easy to enter the appropri- ate formula directly into the spreadsheet. For example, you could enter the spreadsheet version of the future value equation into cell A6: =1OO*(1.O5)A5. Here, = tells the spreadsheet that a formula is being entered into the cell; * is the spreadsheet multiplication sign; and A is the spreadsheet exponential, or power, sign. When this formula is entered into cell A6, the value $127.63 appears in the cell (when formatted with a dollar sign to two decimal places). Note that different spreadsheet programs use slightly different syntax in their time value analyses. The examples presented in this text use Excel syntax.
In most situations, it is more useful to enter a formula that can accommodate changing input values than to embed values in the formula, so it would be better to solve this future value problem with this formula: =A3*(1+A4)AA2, as done in cell A8. Here, the present value ($100) is contained in cell A3, the interest rate (0.05, which is displayed as 5.0%) in cell A4, and the number of periods (5) in cell A2. With this formula, future values can be easily calculated with different starting amounts, interest rates, or number of years by changing the values in the input cells.
Most time value solutions are preprogrammed in the spreadsheet soft- ware. The preprogrammed time value formulas are called functions. Like any formula, a time value function consists of a number of arithmetic calculations combined into one statement. By using functions, spreadsheet users can save the time and tedium of building formulas from scratch.
Chapter 4: Time Value Analysis 133
Each function begins with a unique name that identifies the calcula- tion to be performed, along with one or more arguments (the input values for the calculation) enclosed in parentheses. The best way to access the time \ iluc functions is to use the spreadsheet’s function wizard (also called the function). For this future value problem, first move the cursor to cell •XI0 (the cell where you want the answer to appear). Then, click on the func- tion wizard; select “Financial” for the function category and “Fv” (future value) for the function name; and enter A4 for Rate, A2 for Nper (number of periods), and -A3 for Pv. (Note that the Pmt and Type entries are left blank for this problem. Also note that the cell address entered for Pv has a minus sign. This is necessary for the answer to be displayed as a positive number.) Press OK, and the result—$127.63—appears in cell A10.
Most of the spreadsheet solutions shown in this book follow a simi- lar format. The input values and the output are contained in Column A. If a spreadsheet function is used in the solution, the input value (argument) names are shown in Column B to the right of the input values. In addition, the formula or function used to calculate the output is shown in Column B to the right of the output value. Finally, Column C contains the descriptive input names.
The most efficient way to solve most problems involving time value is to use a spreadsheet. However, the basic mathematics behind the calculations must be understood to set up complex problems before solving them. In addition, the underlying logic must be understood to comprehend stock and bond valuation, lease analysis, capital budgeting analysis, and other important healthcare financial management topics.
To help you better understand time value solution techniques, we use a consistent format in the illustrations presented in this chapter:
• We lay out the situation on a time line and show the equation that must be solved.
• We present the regular calculator solution, if applicable. • We present the spreadsheet formula or function (or both) in a
spreadsheet format.
Graphic View of the Compounding (Growth) Process Exhibit 4.1 shows how $1, or any other lump sum, grows over time at vari- ous rates of interest. The data used to plot the curves can be obtained by using any of the solution techniques described in the previous section. Note that the greater the rate of interest, the faster the growth rate. Thus, $100 on deposit for ten years at a 5 percent interest rate will grow to $162.89, but the same amount invested at 10 percent interest will grow to $259.37. The interest rate is, in fact, a growth rate: If a lump sum is deposited and earns 5 percent interest, the funds on deposit will grow at a rate of 5 percent per
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134 Understanding Healthcare Finance Management
EXHIBIT 4.1
Relationships Among Future Value, Interest
Rates, and Time
Value ($)
Period 5% 10% 15%
1 1.0500 1.1000 1.1500 2 1.1025 1.2100 1.3225 3 1.1576 1.3310 1.5209 4 1-2155 1.4641 1-7490 5 1-2763 1.6105 2.0114 6 1.3401 1-7716 2.3131 7 1.4071 1.9487 2.6600 8 1-4775 2.1436 3-0590 9 1-5513 2-3579 3-5179
10 1.6289 2-5937 4.0456
period. Also note that future value concepts are not restricted to bank depos- its; they can be applied to any growing, or declining, numerical value such as number of clinic visits or earnings per share.
The Power of Compounding It is important to understand what is commonly called the power of compound- ing. A relatively small starting value can grow to a large amount over a long
period, even when the rate of growth (interest rate) is modest. For example, assume that a new parent places $1,000 in a mutual fund to help pay her child’s college expenses, which are expected to begin in 18 years. If the mutual fund—a common stock fund holding a large number of securities— earns a return of 10 percent per year, after 18 years the value of the mutual fond account will be $5,560, which is not an inconsequential sum. (Histori- cally, 10 percent has been considered a reasonable estimate for annual returns on a well-diversified portfolio of stocks. However, the experience of the past decade, wherein the return on stocks has been about zero, has caused many people to question the validity of the 10 percent return assumption.)
Now, assume that the money is meant to help fund the child’s retire- ment, which, hypothetically, will occur 65 years into the future. The value of the mutual fund account at that time will be $490,371, or nearly a half- million dollars, all because of the power of compounding! The moral of this story is clear: When saving for retirement, or for any other purpose, start early.
1. What is compounding? What is interest on interest? 2. What is the basic equation for calculating the future value of a
lump sum? 3. What are three solution techniques for solving lump sum
compounding problems? Which technique is the most efficient? 4. What is meant by the power of compounding?
SELF-TEST QUESTIONS
Present Value of a Lump Sum (Discounting)
Suppose that GroupWest Health Plans, which has premium income reserves to invest, has an opportunity to purchase a low-risk security that will pay $127.63 at the end of five years. A local bank is offering 5 percent interest on a five-year certificate of deposit (CD), and GroupWest’s managers believe that the security is as safe as the bank CD. The 5 percent interest rate avail- able on the bank CD is GroupWest’s opportunity cost rate., in that it has the opportunity to earn that return on an investment similar to the security under consideration. (Opportunity costs are discussed in detail in the next section.) How much would GroupWest be willing to pay for this security?
In the previous section, we learned that an initial amount of $100 invested at 5 percent per year would be worth $127.63 at the end of five years. Thus, GroupWest should be indifferent to the choice between $100 today and $127.63 to be received after five years. Today’s $100 is defined as the present value, or Pv, of $127.63 due in five years when the opportunity
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136 Understanding Healthcare Finance Management
cost rate is 5 percent. If the price of the security is less than $100, Group- West should buy it. If the price is greater than $100, Group West should turn the offer down. If the price is exactly $100, GroupWest can buy it or turn it down because $100 is the security’s fair value. In general, the present value of a cash flow due N years in the future is the amount that, if it were on hand today, would grow to equal the future amount when compounded at the opportunity cost rate.
Finding present values is called discounting, and it is simply the reverse of compounding: If the Pv is known, compound to find the Fv; if the Fv is known, discount to find the Pv. Here are the solution techniques for this discounting problem.
4 5
$127.63
To develop the discounting equation, solve the compounding equa- tion for Pv:
Key Equation 4.2: Present Value of a Lump Sum
Compounding: FvN = Pv x (I + I)N. Fv Discounting: Pv = -—. (1+1)
Regular Calculator Solution Enter $127.63 and divide it five times by 1.05:
$100 = 1.05-5- 1.054- 1.054- 1.054- 1.05 4-$127.63
As shown by the arrows, discounting means moving to the left along a time line. The word discount means to reduce or to lessen, so values decrease when moving to the left along a time line.
Spreadsheet Solution One spreadsheet approach would be to enter the applicable formula, as shown to the right of cell A6: =A3/(1+A4)AA2. Here, the future value ($127.63) is contained in cell A3, the interest rate (0.05, which is displayed as 5.0%) in
Chapter 4: Time Value Analysis 137
cell A4, and the number of periods (5) in cell A2. With this formula, present x alues easily can be calculated for different starting future amounts, interest rates, or number of years.
A B C D
2 5 Nper Number of periods
3 $127.63 Fv Future value
4 5.0% Rate Interest rate
5 6 $100.00 =A3/(I+A4)AA2 (entered into cell A6)
7 8 $100.00 =PV(A4,A2„-A3) (entered into cell A8)
9 10
The function approach is illustrated in cell A8. First, move the cur- sor to the cell in which you want the answer to appear (here, cell A8). Click on the function wizard; select Financial for the function category and Pv (present value) for the function name; and enter A4 for Rate, A2 for Nper (number of periods), and -A3 for Fv. (The Pmt and Type entries are left blank for this problem. Also, the cell address entered for Fv has a minus sign so that the answer will be displayed as a positive number.) Press OK, and the result—$100.00—appears in cell A8.
Graphic View of the Discounting Process Exhibit 4.2 shows how the present value of $1, or any other sum, to be received in the future diminishes as the years to receipt increase. Again, the data used to plot the curves can be developed by using any of the solu- tion techniques. The graphs show that (1) the present value decreases and approaches zero as the payment date is extended further into the future and (2) the greater the rate of decrease, the higher the interest (discount) rate.
Discounting at Work At relatively high interest rates, funds due in the future are worth little today, and even at moderate discount rates, the present value of a sum due in the distant future is small. For an illustration of discounting at work, consider 100-year bonds. A bond is a type of debt security; an investor loans some amount of principal—say, $1,000—to a borrower who promises to pay inter- est over the life of the bond and return the principal amount at maturity. Typically, the longest maturities for bonds are 30 years to 40 years, but in the early 1990s, several firms, including Columbia/HCA Healthcare (now HCA), issued 100-year bonds.
Anyone who would buy a 100-year bond might appear irrational because there is little assurance that the firm will exist in 100 years to repay
138 Understanding Healthcare Finance Management
EXHIBIT 4.2
Relationships Among Present Value, Interest
Rates, and Time
Value
Interest Rate Plot Points
Period 5% 10% 15%
l •9524 •9091 .8696 2 •9070 •8254 •756I 3 .8638 .7513 •6575 4 .8227 .6830 ■5718 5 .7835 .6209 .4972 6 .7462 ■5634 •4323 7 .7107 •5132 •3759 8 .6768 .4665 •3269 9 .6446 .4241 •2843
10 •6139 .3855 •2472
the amount borrowed. However, consider the present value of $1,000 to be received in 100 years. If the discount rate is 7.5 percent—roughly the interest rate set on the bond when it was issued in 1995—the present value is $0.72. The time value of money erodes the value of the principal repayment to a point where it is worth less than $1 when the bond is purchased. Therefore, the value of the bond stems mostly from the interest stream received in the early years of ownership, and the payments expected during the later years of the bond contribute little to the bond’s initial $1,000 value.
Chapter 4: Time Value Analysis 139
1. What is discounting? How is it related to compounding? 2. What are the three techniques for solving lump-sum discounting
problems? 3. What is the basic equation for calculating the present value of a
lump sum? 4. How does the present value of an amount to be received in the
future change as the payment date is extended and the interest rate increases?
SELF-TEST QUESTIONS
Opportunity Costs
In the previous section, the opportunity cost concept was used to set the discount rate needed to analyze Group West’s security investment. This con- cept plays an important role in time value analysis. For example, suppose an individual had the winning ticket for the Florida lottery and now has $1 mil- lion to invest. Should he assign a “cost” to these funds? This money might appear to have zero cost because its acquisition was purely a matter of luck. However, when the lucky individual thinks about what he is going to do with the $1 million, he has to think in terms of the opportunity costs involved. By using the funds to invest in one alternative (for example, in the stock of HMA), the individual forgoes the opportunity to make some other invest- ment (for example, buy US Treasury bonds). Thus, there is an opportunity cost associated with any investment planned for the $1 million, even though the lottery winnings were “free.”
Because one investment decision automatically negates all other pos- sible investments with the same funds, the cash flows expected to be earned from any investment must be discounted at a rate that reflects the return that can be earned on forgone investment opportunities. The problem is that the number of forgone investment opportunities is virtually infinite, so which one should be chosen to establish the opportunity cost rate? The opportunity cost rate to be applied in time value analysis is the rate that can be earned on alternative investments of similar risk. It would not be logical to assign a low opportunity cost rate to a series of risky cash flows, or vice versa. This concept is one of the cornerstones of financial management, so it is worth repeating. The opportunity cost rate (i.e., the discount rate) applied to investment cash flows is the rate that can be earned on alternative investments of similar risk.
The opportunity cost rate does not depend on the source of the funds to be invested. The primary determinant of this rate is the riskiness of the cash flows being discounted. Thus, the same opportunity cost rate would be applied to a potential investment in Tenet Healthcare Corporation stock,
140 Understanding Healthcare Finance Management
whether the funds needed to make the purchase were won in a lottery, taken out of petty cash, or obtained by seeing some landholdings.
Generally, opportunity cost rates are obtained by looking at rates that can be earned or, more precisely, rates that are expected to be earned on secu- rities (such as stocks or bonds). Securities are usually chosen to set opportu- nity cost rates because their expected returns are more easily estimated than rates of return on real assets such as health maintenance organizations, group practices, hospital beds, magnetic resonance imaging (MRI) machines, and the like. Furthermore, as discussed in chapters 6 and 7, securities generally provide the minimum return appropriate for the amount of risk assumed, so securities returns are a good benchmark for other investments.
To better grasp the opportunity cost concept, assume that Oakdale Community Hospital is considering building a nursing home. The first step in the financial analysis is to forecast the cash flows that the nursing home is expected to produce. These cash flows must be discounted at some opportu- nity cost rate to determine their present value. Would the hospital’s oppor- tunity cost rate be (1) the expected rate of return on Treasury bonds; (2) the expected rate of return on the stock of Assisted Living Concepts (ALC), which operates about 200 assisted living centers; or (3) the expected rate of return on pork belly futures? (Pork belly futures are investments that involve commodity contracts for delivery at some future time.) The answer is the expected rate of return on ALC’s stock because that rate of return is expected to be earned on alternative investments of similar risk. Treasury securities are very low-risk investments, so they would understate the opportunity cost rate in owning a nursing home. Conversely, pork belly futures are very high-risk investments, so that rate of return is probably too high to apply to Oakdale’s nursing home investment.2
The source of the funds used for the nursing home investment is not relevant to the time value analysis. Oakdale may obtain the needed funds by borrowing the funds or by soliciting contributions, or it may have accumu- lated excess cash over time. The discount rate applied to the nursing home cash flows depends only on the riskiness of those cash flows and the returns available on alternative investments of similar risk, not on the source of the investment funds.
At this point, you may question the ability of real-world analysts to assess the riskiness of a cash flow stream or to choose an opportunity cost rate with any confidence. Fortunately, the process is not as difficult as it may appear here because businesses have benchmarks that can be used as starting points. (Chapter 9 contains a discussion of how baseline oppor- tunity cost rates are established for capital investments, while Chapter 12 presents a detailed discussion on how the riskiness of a cash flow stream can be assessed.)
Chapter 4: Time Value Analysis 141
1 Why does an investment have an opportunity cost rate even when the employed funds have no explicit cost?
2. How are opportunity cost rates established? 3. Does the opportunity cost rate depend on the source of the
investment funds?
SELF-TEST QUESTIONS
Solving for Interest Rate and Time
In our examples thus far, four time value analysis variables have been used: Pv, Fv, I, and N. Specifically, the interest rate (I) and the number of years (N) plus either Pv or Fv have been given. If the values of any three of the variables are known, the value of the fourth can be found.
Solving for Interest Rate (I) Suppose that Family Practice Associates (FPA), a primary care physician group practice, can buy a bank CD for $78.35 that will return $100 after five years. In this case Pv, Fv, and N are known, but I—the interest rate that the bank is paying—is not known. Such problems are solved in this way:
01 2 3 4 5 I • 1_________I_________I _________I _________I
-$78.35 $100
FvN = Pv x (1 + I)N
$100 = $78.35 X (1 + I)5
Spreadsheet Solution
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A B C D
1 2 5 Nper Number of periods 3 $(78.35) Pv Present value 4 $100.00 Fv Future value 5 6 7 8 5.00% =RATE(A2„A3,A4) (entered into cell A8) 9 10
Here, the spreadsheet function RATE is used to solve for I, as illus- trated to the right of cell A8. First, click on the function wizard; select Finan- cial for the function category and RATE for the function name; and enter A2
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for Nper (number of periods), A3 for Pv, and A4 for Fv. (The Pmt and Type entries are left blank for this problem. Also, the Pv was entered as a negative number, as shown on the time line.) Press OK, and the result—5.00% appears in cell A8. (Some spreadsheet programs display the answer in decimal form unless the cell is formatted to display as a percentage.)
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Solving for Time (N) Suppose that the bank told FPA that a CD pays 5 percent interest each year, that it costs $78.35, and that the group would receive $100 at maturity. How long must the funds be invested in the CD? In this case, Pv, Fv, and I are known, but N—the number of periods—is not known.
Time. Tine
1 1
-$78.35
N I
$100
FVN = Pv x (1 + I)N
$100 = $78.35 x (1.05)N
Spreadsheet Solution
A B C D
1 2 5.00% Rate Number of periods
3 $(78.35) Pv Present value 4 $100.00 Fv Future value 5 6 7 8 5 =NPER(A2,,A3,AZ|) (entered into cell A8) 9 10
To solve for time, the spreadsheet function NPER (number of peri- ods) is used. To begin, place the cursor in cell A8 and click on the function wizard. Then select Financial for the function category and NPER for the function name, and enter A2 for Rate, A3 for Pv, and A4 for Fv. (The Pmt and Type entries are left blank for this problem. Also, the Pv was entered as a negative number, as shown on the time line.) Press OK, and the result—5— appears in cell A8.
The Rule of 72 The Rule of 72 is a simple and quick method for judging the approximate effect of different interest rates on the growth of a lump sum deposit. It tells
Chapter 4: Time Value Analysis 143
uS that to find the number of years required to double the value of a lump sum, merely divide the number 72 by the interest rate paid. For example, if the interest rate is 10 percent, it would take 72/10 = 7.2 years for the money in an account to double in value. The spreadsheet solution is 7.27 years, so the Rule °f 72 is relatively accurate, at least when reasonable interest rates are applied.
In a similar manner, the Rule of 72 can be used to determine the inter- est rate required to double the money in an account in a given number of years. For example, an interest rate of 72/5 = 14.4% is required to double the value of an account in five years. The spreadsheet solution here is 14.9 percent, so the Rule of 72 again gives a reasonable approximation of the cor- rect answer.
1. What are some real-world situations that may require you to solve for interest rate or time?
2. What is the Rule of 72, and how is it used?
SELF-TEST QUESTIONS
Annuities
Whereas lump sums are single dollar amounts, an annuity is a series of equal amounts paid out at fixed intervals for a specified number of periods. Annu- ity amounts, which often are called payments and given the symbol PMT, can occur at the beginning or end of each period. If the payments occur at the end of each period, as they typically do, the annuity is an ordinary annu- ity (also called a deferred, or regular, annuity}. If payments are made at the beginning of each period, the annuity is an annuity due. Because ordinary annuities are, by far, the most common, the term annuity without further description usually means an ordinary annuity.
Ordinary Annuities A series of equal payments at the end of each period constitute an ordinary annuity'. If Meridian Clinic were to deposit $100 at the end of each year for three years in an account that paid 5 percent interest per year, how much would Meridian accumulate at the end of three years? The answer to this question is the future value of the annuity'.
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Time Line
5% 1 3J -$100 -$100
?
144 Understanding Healthcare Finance Management
The future value of any annuity occurs at the end of the final period Thus, for regular annuities, the future value coincides with the last payment
Regular Calculator Solution One approach is to treat each individual cash flow as a lump sum, compound it to Year 3, and then sum the future values:
0 5%
1 L $100
2 3 __I _________I
$100 $100 1 --------> 105 --------------► 110.25
$315-25
Spreadsheet Solution
A B C D
1 2 3 Nper Number of periods
3 $(100.00) Pmt Payment 4 5.0% Rate Interest rate 5 6 7 8 $3i5-25 =FV(A4,A2,A3) (entered into cell A8)
9 10
Here, we again use the Fv function, but now we use the payment (Pmt) entry in the function wizard to recognize that the problem involves annuities. Place the cursor in cell A8. Click on the function wizard; select Financial for the function category and Fv for the function name; and enter A4 for Rate, A2 for Nper (number of periods), and A3 for Pmt. (The Pv and Type entries are left blank for this problem.) Press OK, and the result—$315.25—appears in cell A8.
Suppose that Meridian was offered the following alternatives: (1) a three-year annuity with payments of $100 at the end of each year or (2) a lump-sum payment today. Meridian has no need for the money during the next three years. If it chooses the annuity, it would deposit the payments in an account that pays 5 percent interest per year. Similarly, the lump-sum pay- ment would be deposited into the same account. How large must the lump- sum payment be today to make it equivalent to the annuity? In other words, what is the present value of the annuity?
Chapter 4: Time Value Analysis 145
spreadsheet Solution
A B C D
1 2 3Nper Number of periods
3 $(100.00) Pmt Payment ’4 5.0% Rate Interest rate
S 6 7 8 $272.32 =PV(A4,A2,A3) (entered into cell A8)
9 10
Here, we use the present value function, but again with a payment entry to recognize that the problem involves annuities. Place the cursor in cell A8. Click on the function wizard; select Financial for the function cat- egory and Pv for the function name; and enter A4 for Rate, A2 for Nper (number of periods), and A3 for Pmt. (The Fv and Type entries are left blank for this problem.) Press OK and the result—$272.32—appears in cell A8.
One especially important application of the annuity concept relates to loans with constant payments such as mortgages, auto loans, and many bank loans to businesses. Such loans are examined in more depth in a later section on amortization.
Annuities Due If the three $100 payments in the previous example had been made at the
beginning of each year, the annuity would have been an annuity due. When compared to an ordinary annuity, each payment is shifted to the left one year.
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Because the payments come in faster, an annuity due is more valuable than an ordi- nary annuity.
The future value of our example, assuming it is an annuity due, is found as follows:
0 5% 1 2 3 I____ _____I __________I __________I
-$100 -$100 -$100 ?
The future value of an annuity due occurs one period after the final payment, while the future value of an ordinary
If You Win the Powerball, Should You Take the Annuity or the Cash? Suppose you had won the largest prize in the his tory ofthe Powerball ($590,500,000). With odds reported at 1 in 175,223,510, you would have been very lucky indeed (www.powerball.com/ powerball/pb_prizes.asp). Winners ofthe Pow- erball have two choices for how they can receive their winnings. They can receive 30 annual pay- ments (in your case, 30 x $19,683,333) or in one lump sum (in your case, $370,896,781.) Which option should you choose?
(continued)
146 Understanding Healthcare Finance Management
(continued from previous page)
The first step is to determine the dis- count rate that makes the present value of the annuity due equal to the lump sum; in other words, what is the rate of return that makes the present value of 30 annual pay- ments of $19,683,333 equal to the lump sum of $370,896,781? As a starting point, let’s try a discount rate of 4 percent. The present value of an annuity due at a discount rate of 4 percent and 30 annual payments of $19,683,333 is = PV (4%,30, $19683333».I) = $353,979,444-
This is slightly less than the lump sum, so we know that the discount rate is less than 4 percent. Using Goal Seek, we find that a discount rate of 3.59 percent makes the pres- ent value of the annuity due equal to the lump sum. Now what? If you believe that, through careful investing, you can achieve an average annual rate of return greater than 3.59 percent, you should choose the lump sum and invest it accordingly. However, if you believe that it is unlikely you can achieve an average annual rate of return of 3.59 percent, you should choose the annuity. Of course, there are many other financial factors to consider, such as taxes, liquidity, and other assets and liabilities. There are nonfinancial factors as well, such as your family circumstances and age. An 8o-year-old Powerball winner likely has a different attitude toward a 30-year annuity than a 20-year-old winner does.
annuity coincides with the final payment. (Remember, by definition, the future value of any annuity occurs at the end of die final period; thus, the future value of a three- year annuity occurs at the end of period 3? whether the annuity is a regular annuity or an annuity due.)
Regular Calculator Solution
$100 $100 $100 I ----------►$105
----------------------------► 110.25
-------------------------------------------► 11576_ $33i-oi
In the case of an annuity due, as com- pared with an ordinary annuity, all the cash flows are compounded for one additional period; hence, the future value of an annu- ity due is greater than the future value of a similar ordinary annuity by (1 + I). Thus, the future value of an annuity due also can be found as follows:
Fv (Annuity due) = Fv of a regular annuity x(l+I)
= $315.25 x 1.05 = $331.01.
Spreadsheet Solution
A B C D 1 2 3 Nper Number of periods 3 $(100.00) Pmt Payment 4 5.0% Rate Interest rate 5 6 $331-01 =FV(A4,A2,A3„I) (entered into cell A6) 7 8 $33i-oi =FV(A4,A2,A3)*(I+A4) (entered into cell A8) 9 10
Chapter 4: Time Value Analysis
One approach (as shown in cell A6) is to use the spreadsheet Fv func- tion, but with a “1” entered for Type (as opposed to a blank). Now, the spreadsheet treats the entries as an annuity due, and $331.01 is displayed as the answer. The solution is the same as for an ordinary annuity, except the result must be multiplied by (1 + Rate), which is (1 + A4) in this example. This solution approach is given in cell A8. The result—$331.01—is the future value of the annuity due.
The present value of an annuity due is found in a similar manner:
Time Line
° 1 1
2 1
3 1
-$100 -$100 -$100 ?
Regular Calculator Solution
0 1 2 3 1 5% 1 1
$100 $100 $100 95.24 4
90-70 4 $285.94
The present value of an annuity due can be thought of as the present value of an ordinary annuity that is compounded for one period, so it also can be found as follows:
Pv (Annuity due) = Pv of a regular annuity x (1 + I) = $272.32 x 1.05 = $285.94.
Spreadsheet Solution
A B C D
1 2 3 Nper Number of periods 3 $(100.00) Pmt Payment 4 5.0% Rate Interest rate 5 6 $285.94 =PV(A4,A2,A3„I) (entered into cell A6) 7 8 $285.94 =PV(A4,A2,A3)*(I+A4) (entered into cell A8) 9 10
Understanding Healthcare Finance Management
148
SELF-TEST QUESTIONS
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As with future value, one approach (as shown in cell A6) is to use the spreadsheet Pv function, but with a “1” entered for Type (as opposed to a blank). Now, the spreadsheet treats the entries as an annuity due, and $285.94 is displayed as the answer. Note that the solution is the same as for an ordinary annuity, except the function in cell A8 is multiplied by (1 + A4). The result—$285.94—is the present value of the annuity due.
1. What is an annuity? 2. What is the difference between an ordinary annuity and an annuity
due? 3. Which annuity has the greater future value: an ordinary annuity or
an annuity due? Why? 4. Which annuity has the greater present value: an ordinary annuity
or an annuity due? Why?
Perpetuities
Most annuities call for payments to be made over some finite period—for example, $100 per year for three years—but some annuities go on indefi- nitely, or perpetually. Such annuities are called perpetuities. The present value of a perpetuity is found as follows:
Key Equation 4.3: Present Value of a Perpetuity
. . Payment PMT Pv (Perpetuity) = ------------------=---------.
Interest rate I
For example, some securities issued by General Healthcare, Inc., promise to pay $100 each annually in perpetuity (forever). What would each security be worth if the opportunity cost rate, or discount rate, were 10 per- cent? The answer is $1,000:
Pv (Perpetuity) = $100 0.10
= $1,000.
r Chapter 4: Time Value Analysis 149A B C D 2 3 $100.00 Pmt Payment
4 10.0% Rate Interest rate 5 6 7 8 $1,000.00 =A3/A4 (entered into cell A8)
9 10
Using a spreadsheet, merely enter the perpetuity formula into a cell, as shown in cell A8.
Suppose interest rates, and hence the opportunity cost rate, rose to 15 percent. What would happen to the security’s value? The interest rate increase would lower its value to $666.67:
Pv (Perpetuity) = $100 0.15
= 666.67.
Assume that interest rates fell to 5 percent. The rate decrease would increase the perpetuity’s value to $2,000:
Pv (Perpetuity) = $100 0.05
= $2,000.
As illustrated in the previous equations, the value of a perpetuity changes dramatically when interest (opportunity cost) rates change. All secu- rities’ values are affected when such changes occur, but some types—such as perpetuities and long-term government bonds—are more sensitive to interest rate changes than others. Conversely, securities such as short-term govern- ment bonds (T-bills) and one-year bank certificates of deposit (CDs) are affected much less when rates change. The risks associated with interest rate changes are discussed in more detail in Chapter 6.
1. What is a perpetuity? 2. What happens to the value of a perpetuity when interest rates
increase or decrease?
SELF-TEST QUESTIONS
150 Understanding Healthcare Finance Management
Uneven Cash Flow Streams
The definition of an annuity includes the words constant amount, so annuities involve cash amounts that are the same in every period. Although some finan. cial decisions—such as bond valuation—do involve constant cash amounts most important healthcare financial analyses involve uneven, or nonconstant amounts. For example, the financial evaluation of a proposed outpatient clinic or MRI facility rarely involves constant cash amounts.
In general, the term payment (PMT) is reserved for annuity situations in which the dollar amounts are constant and the term cash flow denotes uneven cash flows (or lump sums).
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Present Value The present value of an uneven cash flow stream is the sum of the present values of the individual cash flows of the stream. For example, suppose Wil- son Memorial Hospital is considering purchasing a new X-ray machine. The hospital’s managers forecast that the operation of the new machine would produce the following stream of cash inflows (in thousands of dollars):
0 L
1 2 1 1—
$100 $120
3 L
$150
What is the present value of the new X-ray machine investment if the appropriate discount (opportunity cost) rate is 10 percent?
Regular Calculator Solution The Pv of each individual cash flow can be found using a regular calculator. Those values are then summed to find the Pv of the stream, $580.95 (from now on, we assume that all values in this example are expressed in thousands):
$580.95
Chapter 4: Time Value Analysis 151
Spreadsheet Solution
A B C D
1 2 10.0% Rate Interest rate
3 4 $100 Value 1 Year 1 CF 5 $120 Value 1 Year 2 CF
6 $150 Value 1 YeanCF
7 $l80 Value 1 Year 4 CF 8 $250 Value 1 Year 5 CF 0
10 $580.95 =NPV(A2,A4:A8)(entered into cell A10)
The NPV function calculates the present value of a series, called a spreadsheet range, of cash flows. First, enter the cash flow values into con- secutive cells in the spreadsheet, as shown in cells A4 through A8. Next, place the discount (opportunity cost) rate in a cell (as in cell A2 above). Then, place the cursor in cell A10, use the function wizard to select Financial and NPV, and enter A2 as Rate and A4:A8 as Value 1. Press OK, and the value—$580.95—appears in the cell. (The Value 1 entry is the range of cash flows contained in cells A4 through A8. Also, NPV stands for net present value, which indicates that the resulting present value is the net of the present values of two or more cash flows.)
The NPV function assumes that cash flows occur at the end of each period, so NPV is calculated as of the beginning of the period of the first cash flow specified in the range, which is one period before the cash flow occurs. Because the cash flow specified as the first flow in the range is a Year 1 value, the calculated NPV occurs at the beginning of Year 1, or the end of Year 0, which is correct for this illustration. However, if a Year 0 cash flow is included in the range, the NPV would be calculated at the beginning of Year 0, or the end of Year -1, which typically is incorrect. This problem will be addressed in the next major section.
Future Value The future value of an uneven cash flow stream is found by compounding each payment to the end of the stream and then summing the future values.
Regular Calculator Solution The future value of each individual cash flow can be found using a regular calculator. Those values are then summed to find the future value of the stream, $935.63:
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152 Understanding Healthcare Finance Management
o L 10%
I
$100
2 I
$120
3 l $150 $180
5 ____I $250.00 198.00 181.50
15972 146.41
$935.63
4
Spreadsheet Solution Most spreadsheet programs do not have a function that computes the future value of an uneven cash flow stream. However, future values can be found by building a formula in a cell that replicates the regular calculator solution.
SELF-TEST QUESTIONS 1. Give two examples of financial decisions that typically involve
uneven cash flows. 2. Describe how present values of uneven cash flow streams are
calculated by (a) using a regular calculator and (b) using a spreadsheet.
3. What is meant by NPV?
Using Time Value Analysis to Measure ROI
In most investments, an individual or business spends cash today with the expectation of receiving cash in the future. The financial attractiveness of such investments is measured by return on investment (ROI)., or just return. There are two basic ways of expressing ROI: (1) in dollar terms and (2) in percentage terms.
To illustrate the concept, let’s reexamine the cash flows expected to be received if Wilson Memorial Hospital buys its new X-ray machine (shown on the time line in thousands of dollars). In the last section, we determined that the Pv of these flows, when discounted at a 10 percent rate, is $580.95:
Chapter 4: Time Value Analysis
5 —J $250
155-23 <
$580-95
Dollar Return The $580.95 represents the present value (in financial terms) of the cash flows that the X-ray machine is expected to provide to Wilson Memorial Hospital. These cash flows are not known with certainty but are the best estimates of the hospital’s managers.
To measure the dollar return on the investment, typically called NPV, the cost of the X-ray machine must be compared to the present value of the expected benefits (the cash inflows). If the machine is expected to cost $500 and the present value of the inflows is $580.95, then the machine’s NPV is $580.95 - $500 = $80.95. (Because these amounts are in thousands, the actual NPV is $80,950.) Note that this measure of dollar return incorpo- rates time value through the discounting process. Also, the opportunity cost inherent in the use of the $500,000 is accounted for because the 10 percent discount rate reflects the return that can be earned on alternative invest- ments of similar risk. Thus, the machine is expected to produce an $80,950 return above that required for its riskiness as accounted for by the 10 percent opportunity cost rate.
The dollar return process can be combined into a single calculation by adding the cost of the machine to the time line:
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154 Understanding Healthcare Finance Management
Spreadsheet Solution
A B C
1 2 10.0% Rate Interest rate 3 $(500) Year 0 CF 4 $100 Value 1 Year 1 CF 5 $120 Value 1 Year2CF
6 $150 Value 1 YeamCF 7 $180 Value 1 Year 4 CF
8 $250 Value 1 YearsCF '
9 10 $80.95 =NPV(A2,A4:A8) + A3 (entered into cell A10)
The situation here is the same as in the previous cash flow stream, which did not include the cost of the machine, except there is an initial investment outlay of $500 in cell A3. Because the NPV of the cash inflows in cells A4 through A8 represents the value one period before the first (A4) cash flow, we just add the investment outlay to the calculated NPV. This calculation is done in cell A10 by adding A3 to the NPV function. The result—$80.95—appears in that cell.
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UHFM7
Rate of Return The second way to measure ROI is by rate of return, or percentage return. Rate of return measures the interest rate that must be earned on the invest- ment outlay to generate the expected cash inflows. In other words, this mea- sure provides the expected periodic rate of return on the investment. If the cash flows are annual, as in this example, the rate of return is an annual rate. In effect we are solving for I, the interest rate that equates the present value of the cash inflows to the dollar amount of the cash outlay.
Mathematically, if the Pv of the cash inflows equals the investment outlay, the NPV of the investment is forced to $0. This relationship is shown here:
IRR%
$ 0
Chapter 4: Time Value Analysis 155
The rate of return on an investment, particularly an investment in plant or equipment, typically is called the internal rate of return (IRR), a somewhat archaic term that is still used instead of RO I or just rate of return. Although a trial-and-error procedure can be used on a regular calculator to determine IRR, it is better to use a financial calculator or spreadsheet.
Spreadsheet Solution
A B C D
1 2 $(500) Values Year 0 CF 3 $100 Values YeariCF 4 $120 Values Year 2 CF 5 $150 Values YeanCF 6 $180 Values YearZfCF
7 $250 Values Year 5 CF 8 9 15-3% =IRR(A2:A7) (entered into cell A9)
The IRR function is used to calculate rate of return. The entry in the function (A2:A7) specifies the range of cash flows to be used in the spread- sheet calculation. The answer—15.3%—is displayed in cell A9.
We have much more to say about investment returns in chapters 6, 7, 11, and 12. For now, an understanding of the basic concept is sufficient.
1. What does ROI mean? 2. Differentiate between dollar return and rate of return. 3. Is the calculation of ROI an application of time value analysis?
Explain your answer.
SELF-TEST QUESTIONS
Semiannual and Other Compounding Periods
In all the examples thus far, we assumed that interest is compounded once a year, which is called annual compounding. Suppose, however, that Meridian Clinic puts $100 into a bank account that pays 6 percent annual interest, but it is compounded semiannually, which means interest is paid each six months, so interest is earned more often under semiannual compounding than under annual compounding. How much would the clinic accumulate at the end of one year, two years, or some other period?
For an illustration of semiannual compounding, assume that the $100 is placed into the account for three years. The following situation occurs under annual compounding:
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156 Understanding Healthcare Finance Management
Time. Line
FvN = Pv x (1 + I)N = $100 x (1.06)3
Spreadsheet Solution
A B C D
1 2 3 Nper Number of periods 3 $100.00 Pv Present value 4 6.0% Rate Interest rate
5 6 $119.10 =IOO*(I.O6)A3 (entered into cell A6)
7 8 $119.10 =A3*(I+AZ,)AA2 (entered into cell A8)
9 10 $119.10 =Fv(A4,A2,,-A3)(entered into cell A10)
Now, consider what happens under semiannual compounding. Because interest rates usually are stated as annual rates, this situation would be described as 6 percent interest, compounded semiannually. With semian- nual compounding, N = 2 x 3 = 6 semiannual periods, and I = 6/2 = 3% per semiannual period. Here is the solution:
0 3% 1 2 3 4 5 6
I___ I ________________I __________I __________I __________I__________I -$ioo ?
FVN = Pv x (1 + I)N = $100 x (1.03)6
Spreadsheet Solution
A B C D 1 2 Nper Number of periods 3 $100.00 Pv Present value 4 3.0% Rate Interest rate 5 6 $119.41 =IOO*(I.O3)A6 (entered into cell A6) 7 8 $119-41 =A3*(I+A4)
AA2 (entered into cell A8)
9 10 $119.41 =Fv(A4,A2„-A3)(entered into cell Aio)
The $100 deposit grows to $119.41 under semiannual compound- ing, but only to $119.10 under annual compounding. This result occurs
Chapter 4: Time Value Analysis 157
because interest on interest is earned more frequently under semiannual compounding. Throughout the economy, different compounding periods are used
for different types of investments. For example, bank accounts often com- pound interest monthly or daily, most bonds pay interest semiannually, and stocks generally pay quarterly dividends.3 Furthermore, the cash flows stem- ming from capital investments—such as a new hospital wing or new diagnos- tic equipment—can be analyzed in monthly, quarterly, or annual periods or some other interval. Time value analyses with different compounding periods must be put on a common basis to make meaningful comparisons.
The stated, or nominal, interest rate in the Meridian Clinic semian-
nual compounding example is 6 percent. The effective annual rate (EAR), which accounts for intra-year compounding, is the rate that produces the same ending value under annual compounding. In the example, the EAR is the rate that would produce a future value of $119.41 at the end of Year 3 under annual compounding. The solution, using Excel’s EFFECT function, is 6.09 percent:
1 B C D
6% Nominal rate Nominal interest rate
2 Npery Number of periods in year
6.09% =EFFECT(A3,Azj) (entered into cell A7)
Thus, if one bank offered to pay 6 percent interest with semiannual compounding on a savings account while another offered 6.09 percent with annual compounding, both banks would be paying the same EAR because the ending value is the same under both sets of terms:
Semiannual periods: 0 ,0/ 1 2 3 4 5 6 I___3/0 1 ________I ________I _________I _________I ________I
$100 x 1.03 x 1.03 x 1.03 x 1.03 x 1.03 x 1.03 = $119.41
Key Equation 4.4: Effective Annual Rate The EAR can be determined, if given the stated rate and number of compounding periods per year, by using this equation:
Effective annual rate (EAR) = (1 + IStated / M)M - 1.0.
Here, I is the stated (nominal or annual) interest rate and M is the number of compounding periods per year. Note that the term Stated / M is the periodic interest rate, so the EAR equation can be restated as follows:
Effective annual rate (EAR) = (1 + Periodic rate)M - 1.0.
For an illustration of the use of the EAR equation, consider the situ- ation of a stated rate of 6 percent and semiannual compounding. Here, the EAR is 6.09 percent:
EAR = (1 + 0.06 / 2)1 2 * - 1.0
= (1.03)2 - 1.0
= 1.0609 - 1.0 = 0.0609 = 6.09%.
For another illustration of the EAR concept, consider the interest rate charged on credit cards. Many banks charge 1.0 percent per month and, in their advertising, state that their annual percentage rate (APR) is 12.0 per- cent.4 However, the true cost rate to credit card users is the effective annual rate of 12.7 percent:
EAR = (1 + Periodic rate)M - 1.0
= (1.01)12 - 1.0 = 0.127 = 12.7%.
In time value analyses, semiannual compounding—or any compound- ing that occurs more than once a year—can be handled two ways. First, the input variables can be expressed as periodic variables rather than annual variables. In the Meridian Clinic example, use N = 6 periods rather than N = 3 years, and I = 3% per period rather than 1 = 6% per year. Second, find the EAR and then use it as an annual rate over the actual number of years. In the example, use I = 6.09% and N = 3 years.
SELF-TEST QUESTIONS 1. What changes must be made in the calculations to determine
the future value of an amount being compounded at 8 percent semiannually versus one being compounded at 8 percent annually?
Chapter 4: Time Value Analysis 159
2. From an investor’s standpoint, why is semiannual compounding better than annual compounding?
3. How does the EAR differ from the stated (nominal) rate?
Amortized Loans
One important application of time value analysis involves loans that are to be paid off in equal installments over time, such as automobile loans, home mortgage loans, and most business debt other than very short-term loans and long-term bonds. If a loan is to be repaid in equal periodic amounts— monthly, quarterly, or annually—it is called an amortized loan. The word amortize comes from the Latin mors, meaning death, so an amortized loan is one that is “killed off’ over time.
For example, suppose Santa Fe Healthcare System borrows $1 million from the Bank of New Mexico, to be repaid in three equal installments at the end of each of the next three years. The bank is to receive 6 percent interest on the loan balance that is outstanding at the beginning of each year. The first task in analyzing the loan is to determine the amount Santa Fe must repay each year, or the annual payment. To find this amount, recognize that the loan represents the present value of an annuity of PMT dollars per year for three years, discounted at 6 percent.
SELF-TEST QUESTIONS
On the web at: ache.org/books/ UHFM7
1 1
0 L 6%
$1,000,000 PMT
2 3 J I PMT PMT
Spreadsheet Solution
A B C D
1 2 6.0% Rate Interest rate
3 3 Nper Number of periods 4 $1,000,000 Pv Present value 5 6 7 8 $374.no =PMT(A2,A3,-A4) (entered into cell A8) 9 10
Therefore, if Santa Fe pays the bank $374,110 at the end of each of the next three years, the percentage cost to Santa Fe, and the rate of return to the bank, will be 6 percent.
Understanding Healthcare Finance Management
Each payment consists partly of interest and partly of repayment of principal. This breakdown is given in the amortization schedule shown Exhibit 4.3. The interest component is largest in the first year, and it declines as the outstanding balance of the loan is reduced over time. Coincidentally the amount of the annual payment that is used to repay the principal amount of the loan increases over time. For tax purposes, a taxable business borrower reports the interest payments in column 3 as a deductible expense each year while the lender reports these same amounts as taxable income.
The spreadsheet function PPMT can be used to construct the amortiza- tion table. This function calculates the principal payment for any given input year
SELF-TEST QUESTIONS 1. When constructing an amortization schedule, how is the periodic
payment amount calculated? 2. Does the periodic payment remain constant over time? 3. Do principal and interest remain constant over time? Explain your
answer.
A Review of Interest Rate Types
This chapter covers many time value concepts, including three different types of interest rate. In this section, we review these rates.
Stated Rate The stated (nominal) rate is the rate stated in financial contracts. Convention in the stock, bond, mortgage, commercial loan, consumer loan, and other
EXHIBIT 43
Loan
Amortization Schedule Year
Beginning Amount
(1) Payment
(2) Interest0
(3)
Repayment of Principal5
(4)
Remaining Balance
(5)
1 $1,000,000 $ 374,no $ 60,000 $ 314,110 $685,890 2 685,890 374,no 41,153 332,957 352,933 3 352,933 374,no 21,177 352,933 0
$1,122,330 $122,330 $1,000,000
“Interest is calculated by multiplying the loan balance at the beginning of each year by the interest rate. Therefore, interest in Year l is $1,000,000 x 0.06 = $60,000; in Year 2 is $685,890 x 0.06 = $41,153; and in Year 3 is $352,933 x 0.06 = $21,177. "Repayment of principal is equal to the payment of $374,110 minus the interest charge for each year.
r Chapter 4: Time Value Analysismarkets is to express loan terms in stated rates, which typically are annualrates However, if compounding is not annual, the stated rate must indicate the number of compounding periods per year. For example, a bank savings account may offer 4 percent interest compounded quarterly, or a money market mutual fund may offer a 3 percent rate, with interest paid monthly. The stated rate is not used for calculations (i.e., never use IStated on a time line, on a calculator, or in a spreadsheet formula or function) unless compound- ing occurs once a year (M = 1). In this case, IStated = Periodic rate = Effective annual rate.
Periodic Rate The periodic rate is the rate charged by a lender or paid by a borrower, or any other time value rate, expressed on a per period basis. The rate can be per year, per six months, per quarter, per month, per day, or per any other time interval. For example, a bank may charge 1 percent per month on its credit card loans, or a finance firm may charge 3 percent per quarter on consumer loans.
Periodic rate = IStatcd/M, which implies that IStated = Periodic rate x M, where M is the number of compounding periods per year. For example, consider the finance firm loan at 3 percent per quarter:
L , = Periodic rate x M = 3% x 4 = 12%, Stated ’
and
Periodic rate = IStated / M = 12% / 4 = 3% per quarter.
The periodic rate can be used when cash flows occur more frequently than once a year and the number of cash flows per year corresponds to the number of compounding periods per year. Therefore, for a retirement annuity that provides monthly payments, a semiannual payment bond, a consumer loan with quarterly payments, or a credit card loan with monthly payments, the calculations would use Periodic rate = IStatcd/M. The implica- tion in all these examples is that the interest compounding period is the same as the cash flow period. Thus, the periodic rate can be used directly in calculations only when the cash flow period coincides with the inter- est rate compounding period (i.e., quarterly payments and quarterly compounding).
Effective Annual Rate The EAR is the rate that, under annual compounding (M = 1), would pro- duce the same results as a given stated rate with compounding that occurs more frequently than annually (M > 1). The EAR is found as follows:
162 Understanding Healthcare Finance Management
EAR=(l+ISmd/M)“-1.0 = (1 + Periodic rate)M - 1.0.
For example, suppose that you can use either a 1 percent per month credit card loan or a 3 percent per quarter consumer loan to make a purchase Which one should you choose? To answer this question, you must express the cost rate of each alternative as an EAR.
0.01)- -1.0 = (1.0D- -1.0
= 1.127 - 1.0 = 0.127= 12.7%.
EARConsumerloan= (1 + 0.03)4 - 1.0 = (1.03)4 - 1.0
= 1.126 - 1.0 = 0.126 = 12.6%.
Thus, the consumer loan is slightly less costly than the credit card loan. This result should have been intuitive because, although both loans have the same 12 percent stated rate, monthly payments would have to be made on the credit card, while under the consumer loan terms, only quarterly pay- ments would have to be made.
The EAR is also used when the interest rate compounding period occurs more often than the period between payments or cash flows. For example, if payments occur semiannually, but interest is compounded quar- terly, then the EAR must be used. In this case, the EAR is really an “effective semiannual rate” calculated as (1 + IStated/4)2 - 1.0, which is then applied to the semiannual payment stream.
SELF-TEST QUESTIONS 1. Define the stated rate, the periodic rate, and the effective annual
rate. 2. How are these three rates related? 3. Can you think of a situation in which all three of these rates are
the same?
Chapter Key Concepts Financial decisions often involve situations in which future cash flows must be valued. The process of valuing future cash flows is called time value analysis. Here are the key concepts behind this type of analysis:
• Analysts use time lines to lay out the cash flows involved in a time value analysis.
Chapter 4: Time Value Analysis 163
• Compounding is the process of determining the future value (Fv) of a lump sum, an annuity, or an uneven cash flow stream.
• Discounting is the process of finding the present value (Pv) of a lump sum, an annuity, or an uneven cash flow stream.
• An annuity is a series of equal, periodic cash flows, which are often called payments (PMT).
• If an annuity’s payments occur at the end of each period, it is called an ordinary annuity.
• If each annuity payment occurs at the beginning of the period rather than at the end, the annuity is an annuity due.
• A perpetuity is an annuity that lasts forever. • If an analysis involving more than one cash amount docs not meet
the definition of an annuity, it is called an uneven cash flow stream. • The financial attractiveness of an investment is measured by its
return on investment (ROI). • ROI can be measured in either dollar or percentage terms. • Dollar return is measured by net present value (NPV)y while
percentage return is measured by internal rate of return (IRR). • The stated (nominal) rate is the annual rate normally quoted in
financial contracts. • The periodic rate is the stated rate divided by the number of
compounding periods per year. • If compounding occurs more frequently than once a year, it is
often necessary to calculate the effective annual rate (EAR), which is the rate that produces the same results under annual compounding as it does under more frequent compounding.
• An amortized loan is one that is paid off in equal amounts over a specified number of periods. An amortization schedule shows the amount of each payment that represents interest, the amount used to reduce the principal, and the remaining balance on each payment date.
Time value analysis is one of the cornerstones of healthcare financial management, so you should feel comfortable with this material before moving ahead.
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
L
164 Understanding Healthcare Finance Management
• A chapter model that shows how to perform many of the calculations described in the chapter
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and that tests
your ability to perform the calculations in preparation for a case
These resources can be accessed on this book’s companion website at ache. org/books/UHFM7.
Selected Case
One case in Cases in Healthcare Finance, 5 th edition, can help you learn more about time value analysis:
® Case 12: Gulf Shores Surgery Centers, which examines the time value analysis techniques discussed in this chapter.
Selected Resources
• Owner’s manual for your calculator • After-market reference manual for your spreadsheet software • Help menu for your spreadsheet software
Selected Website
• Many websites feature time value analysis calculators. For example, see www. easysurf.ee/vfp t2. htm.
Notes
1. Time value analyses can be performed using mathematical multipliers obtained from tables. At one time, tables were the most efficient way to conduct time value analyses, but new technology (calculators and computers) have made tabular solutions obsolete.
2. Actually, owning a single nursing home is riskier than owning the stock of a firm that has a large number of nursing homes with geographic diversification. Also, an owner of ALC’s stock can easily sell the
Chapter 4: Time Value Analysis 165
stock if things go sour, whereas it would be much more difficult for Oakdale to sell its nursing home. These differences in risk and liquidity suggest that the true opportunity cost rate is probably higher than the return that is expected from owning the stock of a large long- term care company. However, direct ownership of a nursing home implies control, while ownership of the stock of a large firm usually does not. Control rights tend to reduce the opportunity cost rate. The main point here is that, in practice, it may not be possible to obtain a “perfect” opportunity cost rate. Nevertheless, an imprecise one is better than none at all.
3. Some financial institutions pay interest that is compounded continuously. Continuous compounding is not relevant to healthcare financial management, so it is not discussed here.
4. The annual percentage rate (APR) and annual percentage yield (ARY) are terms defined in Truth in Lending and Truth in Savings laws. APR is defined as Periodic rate x Number of compounding periods per year, so it ignores the consequences of compounding. Although the APR on a credit card with interest charges of 1.0 percent per month is 1.0% x 12 = 12.0%, the true effective annual rate as calculated in the text is 12.7 percent.
166 Understanding Healthcare Finance Management
Integrative Application
The Problem
Achieve Rehabilitation in Kansas City has decided to expand its outpatient department. The building consultants retained by Achieve estimate that, if the building were constructed today, the capital cost would be approximately $15 million. However, the building consultants estimate that construction costs will increase by 2.5 percent per year over the next three years, due to shortages of some materials and labor.
Achieve is considering two banks for a building fund. First, Great Plains Bank offers a CD that pays a 5.0 percent interest rate, compounded quarterly. In this account, all funds—whether invested for one, two, or three years-must remain on deposit until the end of the three years. Second, Mid-West Bank offers a money market account that pays 4.95 percent, compounded daily. In this account, all funds may be withdrawn at any time. Achieve projects that it will be able to invest $2.5 million immediately, $5 million in one year, and $7.5 million in two years.
Achieve wants to ensure that it will have the funds it needs to build the new outpatient facility, but it is also concerned about “locking up” its funds for three years (which the CD would require). Management must decide which bank to use for its building fund.
The Analysis
The first task is to estimate the cost of the new facility three years from now:
Estimated annual rate of increase in building costs Number of years until building is needed Current construction cost of building Estimated construction cost in three years
2.5%
3 $15,000,000
$16,153,359
=FV(rate,nper„pv)
=FV(2.5%,3„$15,OOO,OOO)
=$16,153,359
167
The EAR of the investment at each bank is as follows:
Great Plains Bank Mid-West Bank
Interest rate 5% 4-95% Compounding periods per year 4 365
EAR 5.095% 5.074%
=EFFECT(5%,4) = 5.095%
=EFFECT(4.95%,365) = 5-
074% The CD at Great Plains Bank offers the higher EAR, but management still
needs to determine whether either investment will provide the funds it will need in three years.
The ending amount if Achieve decides on the CD offered by Great Plains Bank is as follows:
Interest rate 5.0% Number of compounding periods per year 4
Years on Deposit
Quarters on Deposit
Ending Amount
1st deposit $2,500,000 3 12 $ 2,901,886 2nd deposit $5,000,000 2 8 $ 5,522,431
3rd deposit $7,500,000 1 4 $ 7,882,090 Total 3 years from now $16,306,407
=FV(rate,nper„pv)
=FV(5%/4,3*4„$2,5OO,ooo) = $2,901,886
=FV(5%/4,2*4„$5,OOO,OOO) = $5,522,431
=FV(5%/4,I*4„$7,5OO,OOO) = $7,882,090
The ending amount if Achieve decides on the money market account offered by Mid-West Bank is as follows:
Interest rate Number of compounding periods per year
4-95% 365
i68 Understanding Healthcare Finance Management
Years on Deposit
Days on Deposit
Ending Amount
1st deposit $2,500,000 3 1,095 $ 2,900,203 2nd deposit $5,000,000 2 730 $ 5,520,294
3rd deposit $7,500,000 1 365 $ 7,880,565 Total 3 years from now $16,301,063
=FV(rate,nper„pv)
=FV(4.95%/365,3*365,,$2,500,000) = $2,900,203
=FV(4.95%/365,2*365„$5,OOO,OOO) = $5,520,294
=FV(4.95%/365,I*365„$7,5OO,OOO) = $7,880,565
The difference between the ending amount and the estimated construc- tion cost in three years for each bank is as follows:
Great Plains Bank Mid-West Bank
Ending amount $16,306,407 $16,301,063 Estimated construction cost $16,153,359 $16,153,359 Difference $ 153,047 $ 147,703
The Decision
Both investments would provide an ending amount sufficient to pay the esti- mated construction cost in three years. Although the money market account with Mid-West Bank would result in an ending balance that is less than the CD with Great Plains Bank, Achieve management decided to invest its funds in the money market account. Management considered that it was worth forgoing ($153,047 - $147,703 =) $5,344 in exchange for the flexibility of being able to withdraw the funds at any time in case of emergencies or changes in construction timing. ■
CHAPTER
FINANCIAL RISK AND REQUIRED RETURN 5 Learning Objectives After studying this chapter, readers should be able to
• explain the concept of financial risk in general terms, • define and differentiate between stand-alone risk and portfolio risk, • define and differentiate between corporate risk and market risk, • explain the capital asset pricing model (CAPM) relationship
between market risk and required return, and • use the CAPM to determine required returns.
Introduction
Two of the most important concepts in healthcare financial management are financial risk and required return. What is financial risk, how is it measured, and what effect does it have on required return and hence managerial deci- sions? Because so much financial decision making involves risk and return, one cannot gain a good understanding of healthcare financial management without having a solid appreciation of risk and return concepts.
If investors—both individuals and businesses—viewed risk as a benign fact of life, it would have little impact on decision making. However, decision makers are, for the most part, averse to risk and believe it should be avoided. If risks must be taken, there must be a reward for doing so. Thus, invest- ments of higher risk—whether an individual investor’s security investment or a radiology group’s investment in diagnostic equipment—must offer higher returns to make the investment financially attractive.
This chapter presents basic risk concepts from the perspectives of indi- vidual investors and businesses. Healthcare managers must be familiar with both contexts because investors supply the capital that businesses need to function. Unfortunately, merely knowing an investment’s risk is not sufficient to make good investment decisions. It is also necessary to translate risk into required rates of return. Thus, the chapter closes with a discussion of the relationship between risk and required return.
169
Understanding Healthcare Finance Management
To Mortgage or Not to Mortgage One of the most perplexing financial issues facing well-to-do individuals is the question of whether to take out a mortgage on a house purchase. Alternatively, how big should the mortgage be? For example, assume a couple is retiring and moving to Florida. They are buying a $300,000 house in The Villages (“Florida’s Friendliest Retirement Hometown”). Because they sold their house in Boston, which they had lived in for 30 years, for $500,000, they could easily pay cash fortheir retirement home. However, the real estate agent in Florida encouraged them to obtain a 20-percent-down ($60,000) mortgage and refinance the remaining $240,000. “After all,” said the agent, “the interest rate on the mortgage balance is only 5 percent, and you can invest the $240,000 saved in stocks and earn 10 percent. Only a fool would buy a house for cash.”
What do you think of the agent’s advice? On the surface, the agent makes sense, but does risk enter into the decision? Assume that the proposed mortgage has a 15-year maturity and the interest rate on 15-year Treasury securities is 4 percent. Is this information relevant to the decision?
The Many Faces of Financial Risk
A full discussion of financial risk would take many chapters, perhaps even an entire book, because financial risk is a cornpli- cated subject. First, it depends on whether the investor is an individual or a business. If the investor is an individual, it depends on the investment horizon, or the amount of time until the investment proceeds are needed. To make the situation even more complex, it may be difficult to define, measure, or translate financial risk into something usable for decision making. For example, the risk that individual investors face when saving for retirement is the risk that the amount of funds accumulated will not be sufficient to fund the lifestyle expected during the full term of retire- ment. Needless to say, incorporating such a definition of risk into investment deci- sions is not easy. The good news is that our primary interest concerns the financial risk inherent in making decisions within busi- nesses. Thus, our discussion focuses on the fundamental factors that influence the
riskiness of real asset investments (land, buildings, equipment, and so on). Still, two factors complicate our discussion of financial risk. The first
complicating factor is that both businesses and investors in businesses are subject to financial risk. There is some risk inherent in the business itself that depends primarily on the type of enterprise. For example, pharmaceuti- cal firms generally face a great deal of risk, while healthcare providers typi- cally have less risk. Investors—stockholders and creditors—bear the riskiness inherent in the business, but the risk is modified by the contractual nature of the securities they hold. For example, the stock of Manor Care is more risky than its debt, although the risk of both securities depends on the inherent risk of a business that operates in the long-term care industry. Not-for-profit firms have the same partitioning of risk, but the inherent riskiness of the busi- ness is split between creditors and the implied stockholders, who generally are considered to be the community at large.
The second complicating factor is that the riskiness of an investment jepends on the context in which it is held. For example, a stock held alone is riskier than the same stock held as part of a large portfolio of stocks. Similarly, a magnetic resonance imaging (MRI) system operated independently is riskier than the same system operated as part of a large, geographically diversified business that owns and operates numerous types of diagnostic equipment.
1. What complications arise when dealing with financial risk in a business setting?
SELF-TEST QUESTION
Introduction to Financial Risk
Generically, risk is defined as “a hazard; a peril; exposure to loss or injury.” Thus, risk refers to the chance that an unfavorable event will occur. If an indi- vidual engages in skydiving, she risks injury or death. If an individual gambles at roulette, he is not risking injury or death but is taking a financial risk. Even when an individual invests in stocks or bonds, she risks losing money in hopes of earning a positive rate of return. Similarly, when a healthcare busi- ness invests in new assets—such as diagnostic equipment, new hospital beds, or a new managed care plan—it is taking a financial risk.
For an illustration of basic financial risk, consider two potential per- sonal investments. The first investment consists of a one-year, $1,000 face- value US Treasury bill (T-bill) bought for $950. Treasury bills are short-term federal debt securities that are sold at a discount (i.e., less than face value) and return face, or par, value at maturity. The investor expects to receive $1,000 at maturity in one year, so the anticipated rate of return on the T-bill invest- ment is 5.26 percent. Using a spreadsheet:
A B C D
1 2 l Nper Number of periods 3 $(950.00) Pv Present value 4 $1,000 Fv Future value 5 6 7 8 5.26% = RATE(A2„A3,A4) (entered into cell A8) 9
10
The $1,000 payment is fixed by contract (the T-bill promises to pay this amount), and the US government is certain to make the payment unless a
Understanding Healthcare Finance Management
national disaster occurs—an unlikely event. Thus, there is virtually a 100 percent probability that the investment will earn the roughly 5.3 percent rate of return expected. In such situations, an investment is defined as riskless, or risk free.1
Now, assume that the $950 is invested in a biotechnology partnership that will be terminated in one year. If the partnership develops a new com- mercially valuable product, its rights will be sold and $2,000 will be received from the partnership, for a rate of return of 110.53 percent:
A B C D
1 2 l Nper Number of periods
3 $(950.00) Pv Present value 4 $2,000 Fv Future value 5 6 7 8 110.53% =RATE(A2„A3,AZ|) (entered into cell 8)
9
10
On the other hand, if nothing worthwhile is developed, the partner- ship will be worthless, no money will be received, and the rate of return will be -100 percent:
A B C D
1 2 1 Nper Number of periods 3 $(950.00) Pv Present value 4 $0.01 Fv Future value 5 6 7 8 -100.00% =RATE(A2„A3,A4) (entered into cell 8)
9 10
Note that spreadsheets give no solution when the future value is entered as zero, but if a very small number—for example, 0.01—is entered for the future value, the solution for interest rate is -100.00 percent.
Now, assume that there is a 50 percent chance that a valuable product will be developed. In this admittedly unrealistic situation, the expected rate of return—a statistical concept that will be discussed shortly—is the same 5.3 percent as on the T-bill investment: (0.50 x 110.53%) + (0.50 x [-100%]) = 5.3%. However, the biotechnology partnership is a far cry from being riskless. If things go poorly, the entire $950 investment will be lost, and the realized rate of return will be -100 percent. Because there is a significant chance of earning a return that is far less than expected, the partnership investment is described as being very risky.
r
— Chapter 5: Financial Risk and Required Return 173
Thus, financial risk is related to the probability of earning a return that is less than expected. The greater the chance of low or negative returns, the greater the amount of financial risk.
1. What is the generic definition of risk? 2. Explain the concept of financial risk in general terms.
Risk Aversion
Why is defining and measuring financial risk so important? The reason is that, for the most part, both individual and business investors dislike risk. Suppose you were given a choice between a sure $ 1 million and the flip of a coin for either $0 or $2 million. You, and just about everyone else, would likely take the $1 million and run. An individual who takes the sure $1 million is risk averse', an individual who is indifferent between the two alternatives, or views them as the same, is risk neutral-, and an individual who prefers the gamble to the sure thing is a risk seeker.
Of course, people and businesses do gamble and take chances, so all of us typically exhibit some risk-seeking behavior. However, most individual investors would never put a sizable proportion of their net worth at risk, and most business executives would never “bet the business” because most people are risk averse when it really matters.
What are the implications of risk aversion for financial decision mak- ing? First, given two investments with similar returns but differing risk, inves- tors will favor the lower-risk alternative. Second, investors will require higher returns to invest in higher-risk investments. These typical outcomes of risk- averse behavior have a significant impact on many facets of financial decision making; hence, they will appear repeatedly in later chapters.
1. What is risk aversion? 2. What are the implications of risk aversion for financial decision
making?
SELF-TEST QUESTIONS
SELF-TEST QUESTIONS
Probability Distributions
The chance that an event will occur is called probability of occurrence, or just probability. For example, a weather forecast might predict a 40 percent chance of rain. Or, when rolling a single die, the probability of rolling a two
174 Understanding Healthcare Finance Management
is one out of six, or 1/6 = 0.1667 = 16.67%. If all possible outcomes related to a particular event are listed, and a probability is assigned to each outcome the result is a probability distribution. In the example of the weather forecast' the probability distribution looks like this:
Outcome
Rain No rain
Probability
0.40 = 40% 0.60 = 60% 1.00 = 100%
In the example of the roll of a die, the probability distribution looks like this:
Outcome
1 2 3 4 5 6
Probability
0.1667 = 16.67% 0.1667 = 16.67% 0.1667 = 16.67% 0.1667 = 16.67% 0.1667 = 16.67% 0.1667 = 16.67% 1.0000 = 100.00%
The Gambler’s Fallacy On August 18,1913, at the casino in Monte Carlo, a rare event occurred at the roulette wheel. (A roulette wheel contains black and red spaces, and the ball has roughly a 50/50 chance of land- ing on either color each time the wheel is spun.) On that day, the ball landed on a black space a record 26 times in a row. As a result, beginning when black had come up a phenomenal 15 times, there was a wild rush to bet on red. As each spin continued to come up black, players doubled and tripled their stakes, and, after 20 spins, many expressed the belief that there was not a chance in a million of another black. By the time the run ended, on the 27th spin, the casino was millions of francs richer.
The players at the roulette wheel that day committed what is known as the gambler’s fal- lacy, also called the Monte Carlo fallacy. Simply (continued)
All possible outcomes (i.e., the number of dots showing after the die roll) are listed in the left column, while the probability of each outcome is listed in the right column and expressed as decimals and percentages. If the probability distri- bution is complete, the probabilities must sum to 1.0, or 100 percent.
Probabilities can also be assigned to possible outcomes—in this case, returns— on personal and business investments. If an individual buys stock, the return will usually come in the form of dividends and capital gains (selling the stock for more than the individual paid for it) or losses (selling the stock for less than the individual paid for it). Because all stock returns are uncertain, there is some chance that the dividends will not be as high as expected, that the stock price will not increase as much as expected,
Chapter 5: Financial Risk and Required Return 175
or that the stock price will even decrease. The higher the probabilities of dividends and stock price well below those expected, the higher the probability that the return will be significantly less than expected and, hence, the greater the risk.
For an illustration of this concept using a business investment, consider a hos- pital evaluating the purchase of a new MRI system. The cost of the system is an invest- ment, and the net cash inflows from patient utilization of the MRI provide the return. The net cash inflows, in turn, depend on the number of procedures, charge per pro- cedure, payer discounts, operating costs, and so on. These values typically are not known with certainty but rather are depen- dent on factors such as patient demograph- ics, physician acceptance, local market con- ditions, labor costs, and so on. Thus, the hospital faces a probability distribution of returns rather than a single return known with certainty. The greater the prob- ability of returns well below the return anticipated, the greater the risk of the MRI investment.
(continued from previous page) put, the fallacy rests on the assumption that some result must be “due” simply because what has previously happened departs from what was expected to happen. In this example, one spin of the roulette wheel does not affect the next spin. Thus, each time the ball is rolled, there is (ide- ally) a 50 percent chance of landing on a black and a 50 percent chance of landing on a red. Even after many blacks have occurred in succession, there is still a 50/50 chance of a red because the results of previous spins have no bearing on the outcome of the next spin—the roulette wheel has no memory.
What do you think of the gambler’s fal- lacy? What conditions must hold for the fallacy to apply? Are there situations that might occur that would cause the fallacy to be correct (past results predict future results)? If people are smart enough to recognize the fallacy, why do Las Vegas casino owners make so much money?
1. What is a probability distribution? 2. How are probability distributions used in financial decision
making?
Expected and Realized Rates of Return
To be most useful, the concept of financial risk must be defined more pre- cisely than just as the chances of a return well below that anticipated. Exhibit 5.1 contains the estimated return distributions developed by the financial staff of Norwalk Community Hospital for two proposed investments: (1) an MRI system and (2) a walk-in clinic. Here, each economic state reflects a combination of factors that determine each project’s profitability. For example, for the MRI project, the very poor economic state signifies very low physician acceptance and hence very low utilization, very high discounts on reimbursements, very high operating costs, and so on. The economic states are defined in a similar fashion for the walk-in clinic.
SELF-TEST QUESTIONS
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Understanding Healthcare Finance Management
EXHIBIT 5.1 Norwalk
Community Hospital:
Estimated Returns for
Two Proposed Investments
Probability Rate of Return if Economic State Occu^ Economic State of Occurrence MRI Clinic Very poor Poor Average Good Very good
0.10 -10% 0.20 0 0.40 10 0.20 20 0.10 30 1.00
-20% 0 15
30 50
The expected rate of return, defined in the statisticalsense, is the weighted average of the return distribution—the weights being the probabili- ties of occurrence.
Key Equation 5.1: Expected Value of a Return Distribution
E(R) = (Probability of return 1 x Return 1)
+ (Probability of return 2 x Return 2)
+ (Probability of return 3 x Return 3) and so on.
For example, the expected rate of return on the MRI system, E(RMR]), is 10 percent:
E(RMRI) = (0.10 X [-10%]) + (0.20 X 0%) + (0.40 x 10%)
+ (0.20 x 20%) + (0.10 x 30%)
= 10.0%.
Spreadsheet Solution
A B c D 1 2 Probability MRI Rate
3 of Occurrence of Return 4 5 0.10 -10% 6 0.20 0%
7 0.40 10% 8 0.20 20% 9 0.10 30% 10 11 10.0% =SUMPRODUCT(A5:A9,C5:C9) (entered into cell An) 12
Chapter 5: Financial Risk and Required Return 177
Calculated in a similar manner, the expected rate of return on the walk-in clinic is 15 percent.
The expected rate of return is the average return that would result, given the return distribution, if the investment were randomly repeated many times. In this illustration, if 1,000 clinics were built in different areas, each of which faced the return distribution given in Exhibit 5.1, the average return on the 1 000 investments would be 15 percent, assuming the returns in each area are independent of one another. However, only one clinic would actually be built, and the realized rate of return could turn out to be less than the expected 15 percent. Therefore, the clinic investment, as well as the MRI investment, is risky.
Expected rate of return expresses expectations for the future. When the managers at Norwalk Community Hospital analyzed the MRI invest- ment, they expected it to earn 10 percent. Now, assume that economic con- ditions took a turn for the worse and the very poor economic scenario occurred. In this case, the realized rate of return, which is the rate of return that the investment produced as measured at termination, would be a nega- tive 10 percent. It is the potential of realizing a return of-10 percent on an investment that has an expected return of +10 percent that produces risk. Note that in many situations, especially those illustrated in textbooks, the expected rate of return is not achievable. For example, an investment that has a 50 percent chance of a 5 percent return and a 50 percent chance of a 15 percent return has an expected rate of return of 10 percent. Yet, there is zero probability of actually realizing the 10 percent expected rate of return.
1. How is the expected rate of return calculated? 2. What is the economic interpretation of the expected rate of return? 3. What is the difference between the expected rate of return and the
realized rate of return?
Stand-Alone Risk
We can look at the two distributions in Exhibit 5.1 and intuitively conclude that the investment in the clinic is riskier than the investment in the MRI system because the clinic has a chance of incurring a 20 percent loss, while the worst possible loss on the MRI system is 10 percent. This intuitive risk assessment is based on the stand-alone risk of the two investments—that is, we are focusing on the riskiness of each investment under the assumption that it would be the business’s only asset (operated in isolation). Portfolio
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V8 Understanding Healthcare Finance Management
effects are introduced in the next section, but for now let’s continue our discussion of stand-alone risk.
Stand-alone risk depends on the “tightness” of an investment’s return distribution. If an investment has a tight return distribution (i.e., a distribu- tion with returns falling close to the expected return), it has relatively lOw stand-alone risk. Conversely, an investment with a return distribution that is “loose” (i.e., a distribution with values well below the expected return) is relatively risky in the stand-alone sense.
It is important to recognize that risk and return are separate attributes of an investment. An investment may have a tight distribution of returns and hence low stand-alone risk, but its expected rate of return might be only 2 percent. In this situation, the investment probably would not be financially attractive, despite its low risk. Similarly, a high-risk investment with a suf- ficiently high expected rate of return would be attractive.1 2
To be useful, any definition of risk must have some measure, or numerical value, so we need some way to specify the “degree of tightness” of an investment’s return distribution. One such measure is the variance:
Key Equation 5.2: Variance of a Return Distribution
Variance = Probability of return 1 x [Rate of return 1 - E(R)]2) + Probability of return 2 x [Rate of return 2 - E(R)]2) and so on.
Variance is a measure of the dispersion of a distribution around its expected value, but it is less useful than standard deviation because its mea- surement unit is percent or dollars squared, which has no economic meaning. Standard deviation, which is often indicated by the symbol o (Greek lower- case sigma), is a common statistical measure of the dispersion of a distribu- tion around its mean—the smaller the standard deviation, the tighter the distribution and hence the lower the riskiness of the investment.
Key Equation 5.3: Standard Deviation of a Return Distribution
Standard deviation = Square root of variance.
For an example calculation of standard deviation, consider the MRI investment’s estimated returns listed in Exhibit 5.1. Here are the steps:
1. The expected rate of return on the MRI, E(RMRI), is 10 percent.2. The variance of the return distribution is determined as follows:
Variance = (0.10 x [-10% - 10%]2) + (0.20 x [0% - 10%]2)
+ (0.40 x [10% - 10%]2) + (0.20 x [20% - 10%]2) + (0.10 x [30% - 10%]2)
= 120.00.
3 The standard deviation is defined as the square root of the variance:
Standard deviation (o) = VVariance
= 7120.00 =10.95%.
Using the same procedure, the clinic investment listed in Exhibit 5.1 was found to have a standard deviation of returns of about 18 percent. Because the clinic investment’s standard deviation of returns is larger than that of the MRI investment, the clinic investment has more stand-alone risk than the MRI investment. As a general rule, investments with higher expected rates of return have larger standard deviations than investments with smaller expected returns have.3 This situation occurs in our MRI and clinic example.
In situations where expected rates of return on investments differ sub- stantially, standard deviation may not provide a good picture of one invest- ment’s stand-alone risk relative to another. The coefficient of variation (CV), which is defined as the standard deviation of returns divided by the expected return, measures the risk per unit of return and hence standardizes the mea- surement of stand-alone risk. For example, note that the MRI investment has a CV of 1.10, while the clinic’s CV is 1.20:
Coefficient of variation = CV = - . E(R)
CVMRI = 11.0% / 10.0% = 1.10.
CVclinic = 18.0% / 15.0% = 1.20.
In this situation, the clinic investment has slightly more risk per unit of return, so it is riskier than the MRI investment as measured by both standard deviation and coefficient of variation. However, the clinic investment’s stand- alone risk as measured by the coefficient of variation is not as great relative to the MRI investment as it is when measured by standard deviation. This difference in relative risk occurs because the clinic investment has a higher expected rate of return. Note that coefficient of variation has no units; it is just a raw number.
i8o Understanding Healthcare Finance Management
SELF-TEST QUESTIONS 1. What is stand-alone risk?
2. What are some measures of stand-alone risk? 3. Is one measure better than another?
□ Portfolio Risk and Return
On the web at. The preceding section developed a risk measure—standard deviation—that- ache.org/books/ , at
UHFMZ applies to investments held in isolation. (We also discussed coefficient of variation, but for now our focus is on standard deviation.) However, most investments are not held in isolation. Instead, they are held as part of a collection, or portfolio, of investments. Individual investors typically hold portfolios of securities (i.e., stocks and bonds), while businesses generally hold portfolios of projects (i.e., product or service lines). When investments are held in portfolios, investors’ primary concern is not the realized rate of return on each individual investment but rather the realized rate of return on the entire portfolio. Similarly, the riskiness of each individual investment in the portfolio is not important to the investor; what matters is the aggregate riskiness of the portfolio. Thus, the whole nature of risk, and how it is defined and measured, changes when one recognizes that investments are not held in isolation but rather as parts of portfolios.
Portfolio Returns Consider the returns estimated for the seven investment alternatives listed
in Exhibit 5.2. The single investment alternatives (investments A, B, C, and D) could be projects under consideration by South West Clinics, Inc., or they could be securities that are being evaluated as personal investments. The remaining three alternatives in Exhibit 5.2 are portfolios. Portfolio AB consists of a 50 percent investment in Investment A and a 50 percent invest- ment in Investment B (e.g., $10,000 invested in A and $10,000 invested in B); Portfolio AC is an equal-weighted portfolio of investments A and C; and Portfolio AD is an equal-weighted portfolio of investments A and D. As shown at the bottom of the table, investments A and B both have a 10 percent expected rate of return, while the expected rates of return for invest- ments C and D are 15 percent and 12 percent, respectively. Investments A and B have identical stand-alone risk (i.e., standard deviations of 11.0 per- cent), while investments C and D have greater stand-alone risk than invest- ments A and B have.
The expected rate of return on a portfolio, is the weighted average of the expected returns on the investments that make up the portfo-
lio, the weights being the proportion of the total portfolio invested in each asset:
Chapter 5: Financial Risk and Required Return 181
EXHIBIT 5.2 Rate of Return if Economic State OccursEconomic
State Probability of Occurrence A B C D AB AC AD
Estimated Returns for
Very poor 0.10 -10% 30% -25% 15% 10% -17.5% 2.5% Four Individual poor 0.20 0 20 -5 10 10 -2.5 5-0 Investments Average 0.40 10 10 15 0 10 12.5 5-0 and Three Good 0.20 20 0 35 25 10 275 22.5 Very good 0.10
1.00 30 -10 55 35 10 42.5 32.5 Portfolios
Expected rate of return 10.0% 10.0% 15.0% 12.0% 10.0% 12.5% 11.0% Standard deviation 11.0% 11.0%21.9% 12.1% 0.0% 16.4% 10.1%
Key Equation 5.4: Expected Return on a Portfolio E(RPottfolio) = (W1 x E[Rll) + (w2 X E[R2]) + (W3 X E[R3B and SO On’ where w, is the proportion of Investment 1 in the overall portfolio and E(Rj) is the expected rate of return on Investment 1, and so on.
Thus, the expected rate of return on Portfolio AB is 10 percent:
E(RAB) = (0.5 x 10%) + (0.5 x 10%) = 5% + 5% =10%,
while the expected rate of return on Portfolio AC is 12.5 percent and on AD, 11.0 percent.
Alternatively, the expected rate of return on a portfolio can be calcu- lated by looking at the portfolio’s return distribution. For example, consider the return distribution for Portfolio AC contained in Exhibit 5.2. The port- folio return in each economic state is the weighted average of the returns on investments A and C in that state. For example, the return on Portfolio AC in the very poor state is (0.5 x [-10%]) + (0.5 x [-25%]) = -17.5%. Portfolio AC’s return in each other state is calculated similarly. Portfolio AC’s return distribution now can be used to calculate its expected rate of return:
E(RAC) = (0.10 x [-17.5%]) + (0.20 x [-2.5%]) + (0.40 x 12.5%)
+ (0.20 x 27.5%) + (0.10 x 42.5%)
= 12.5%.
This value is the same as that calculated from the expected rates of return of the two portfolio components:
E(RAC) = (0.5 x 10%) + (0.5 x 15%) = 12.5%.
182 Understanding Healthcare Finance Management
After the fact, the actual, or realized, returns on investments A and C will probably be different from their expected values; hence, the realized rate of return on Portfolio AC will likely be different from its 12.5 percent expected rate of return.
Portfolio Risk: Two Investments When an investor holds a portfolio of investments, the portfolio is in effect a stand-alone investment, so the riskiness of the portfolio is measured by the standard deviation of portfolio returns, which is the previously discussed measure of stand-alone risk. How does the riskiness of the individual invest- ments in a portfolio combine to create the overall riskiness of the portfolio? Although the rate of return on a portfolio is the weighted average of the returns on the component investments, a portfolio’s standard deviation (i.e., riskiness) is generally not the weighted average of the standard deviations of the individual components. The portfolio’s riskiness may be smaller than the weighted average of each component’s riskiness. Indeed, the riskiness of a portfolio may be less than the least risky portfolio component, and, under certain conditions, a portfolio of risky assets may even be riskless.
A simple example can be used to illustrate this concept. Suppose that an individual is given an opportunity to flip a coin once. If it comes up heads, he wins $10,000, but if it comes up tails, he loses $8,000. This bet is rea- sonable; the expected dollar return is (0.5 x $10,000) + (0.5 x [-$8,000]) = $1,000. However, it is a highly risky proposition; the individual has a 50 percent chance of losing $8,000. Thus, because of risk aversion, most people would refuse to make the bet, especially if the $8,000 potential loss would result in financial hardship.
Alternatively, suppose that individual is given the opportunity to flip the coin 100 times, and he would win $100 for each head but lose $80 for each tail. It is possible, although unlikely, that he would flip all heads and win $10,000. It is also possible but unlikely that he would flip all tails and lose $8,000. The chances arc high that he would flip close to 50 heads and 50 tails and net about $1,000. Even if he flipped a few more tails than heads, he would still make money on the gamble.
Although each flip is a risky bet in the stand-alone sense, collectively the individual has a low-risk proposition. In effect, the multiple flipping has created a portfolio of investments; each flip of the coin can be thought of as one investment, so the individual now has a 100-investment portfolio. Fur- thermore, the return on each investment is independent of the returns on the other investments; the individual has a 50 percent chance of winning on each flip of the coin regardless of the results of the previous flips. By combining the flips into a single gamble (i.e., into an investment portfolio), the gambler can reduce the risk associated with each bet. In fact, if the gamble consisted
Chapter 5: Financial Risk and Required Return 183
of a large number of flips—say, 1,000—almost all risk would be eliminated; the probability of a near-equal number of heads and tails would be high, and the result would be a sure profit. Risk reduction is inherent in the portfolio because the negative consequences of tossing a tail are offset by the positive consequences of tossing a head.
To examine portfolio effects in more depth, consider Portfolio AB in Exhibit 5.2. Each investment (A and B) is risky when held in isolation; each has a standard deviation of returns of 11 percent. However, a portfolio of the two investments has a rate of return of 10 percent in every possible state of the economy; hence, it offers a riskless 10 percent return. This result is verified by the value of zero for Portfolio AB’s standard deviation of returns. The reason investments A and B can be combined to form a riskless portfolio is that their returns have an inverse relationship. Thus, in economic states when A’s returns are relatively low, those of B are relatively high, and vice versa, so the gains on one component in the portfolio exactly offset losses in the other component.
The movement relationship of two variables (i.e., their tendency to move either together or in opposition) is called correlation. The correlation coefficient, r, measures this relationship. Investments A and B can be com- bined to form a riskless portfolio because the returns on A and B are perfectly negatively correlated, which is designated by r = -1.0. In every economic state where Investment A has a return higher than its expected return, Investment B has a return lower than its expected return, and vice versa.
The opposite of perfect negative correlation is perfect positive correla- tion, which is designated by r = +1.0. Returns on two perfectly positively correlated investments move up and down together as the economic state changes. When the returns on two investments are perfecdy positively cor- related, combining the investments into a portfolio will not lower risk; the standard deviation of the portfolio is merely the weighted average of the standard deviations of the two components.
To better understand the impact of perfect positive correlation, con- sider Portfolio AC in Exhibit 5.2:
1. Its expected rate of return, E(RAC), is 12.5 percent. 2. The variance of the portfolio is 270: Variance = (Probability of return 1 x [Rate of return 1 - E(RAC)]1 2) + (Probability of return 2 x [Rate of return 2 - E(RAC)]2) and so on = (0.10 x [-17.5% - 12.5%]2) + (0.20 x [-2.5% - 12.5%]2) + (0.40 x [12.5% - 12.5%]2) + (0.20 x [27.5% - 12.5%]2) + (0.10 x [42.5% - 12.5%]2)
= 270.00.
184 Understanding Healthcare Finance Management
3. Finally, Portfolio AC’s standard deviation is 16.4 percent:
oAC = ^/Variance
= V270.00 =16.4%.
Because there is a perfect positive correlation between the returns on A and C, Portfolio AC’s standard deviation is the weighted average of the component standard deviations:
oAC = (0.5 x 11.0%) + (0.5 x 21.9%)
= 16.4%.
There is no risk reduction in this situation. The risk of the portfolio is less than the risk of Investment C, but it is more than the risk of Investment A. Forming a portfolio does not reduce risk when the returns on the two components are perfectly positively correlated; the portfolio merely averages the risk of the two investments.
What happens when a portfolio is created with two investments that have positive, but not perfectly positive, correlation? Combining the two investments can eliminate some, but not all, risk. To illustrate the concept, consider Portfolio AD in Exhibit 5.2. This portfolio has a standard deviation of returns of 10.1 percent, so it is risky. However, Portfolio AD’s standard deviation is not only less than the weighted average of its components’ stan- dard deviations, (0.5 x 11%) + (0.5 x 12.1%) = 11.6%, but also less than the standard deviation of each component. The correlation coefficient between the return distributions for A and D is 0.53, which indicates that the two investments are positively correlated, but the correlation is less than +1.0. Thus, combining two investments that are positively, but not perfectly, cor- related lowers risk but does not eliminate it.4
Because returns correlation is the factor that drives risk reduction, a logical question here is, What is the correlation among the returns on “real- world” investments? Generalizing about the correlations among real-world investment alternatives is difficult. However, it is safe to say that the return distributions of two randomly selected investments—whether they are real assets in a hospital’s portfolio of projects or financial assets in an individual’s investment portfolio—are almost never perfectly correlated; hence, correla- tion coefficients are rarely -1.0 or +1.0. In fact, it is almost impossible to find actual investment opportunities with returns that are negatively correlated with one another or even to find investments with returns that are uncor- related (r = 0). Because all investment returns are affected to a greater or lesser degree by general economic conditions, investment returns tend to be positively correlated with one another. However, because investment returns are not affected identically by general economic conditions, returns on most real-world investments are not perfectly positively correlated.
Chapter 5: Financial Risk and Required Return 185
The correlation coefficient between the returns of two randomly chosen investments will usually fall in the range of +0.3 to +0.8. Returns on investments that are similar in nature, such as two inpatient projects in a hospital or two stocks in the same industry, typically have return correlations at the upper end of this range. Conversely, returns on dissimilar projects or securities tend to have correlations at the lower end of the range.
For real-world correlations, consider Exhibit 5.3, which shows the correlation coefficients between several investment classes. The table uses securities—primarily stocks—to illustrate correlations because good data are not available on other types of investments. Furthermore, the base for all correlations is the Standard & Poor’s (S&P 500) Index, which is a diversi- fied portfolio of large-firm stocks. The data confirm that even stocks that are considered to move counter to most other stocks—such as gold stocks—have a significant positive correlation with the S&P 500 Index. Because all invest- ments are affected by overall economic conditions, the correlations between returns on most investments are highly positive but not perfectly so.
Portfolio Risk: Many Investments Businesses are not restricted to two projects, and individual investors are not restricted to holding two-security portfolios. Most firms have tens—or even hundreds or thousands—of individual projects (i.e., product or service lines), and most individual investors hold many different securities or mutual funds that may be composed of hundreds or even thousands of individual securities. Thus, what is most relevant to financial decision making is not what happens when two investments are combined into portfolios but rather what happens when many investments are combined.
To better understand the risk impact of creating large portfolios, consider Exhibit 5.4. The graph illustrates the riskiness inherent in ran- domly selected portfolios of one, two, three, four investments, and so on, considering the correlations that occur among real-world investments. The plot is based on historical annual returns on common stocks traded on the New York Stock Exchange (NYSE), but the conclusions are applicable to
Investment 1 Investment 2 Correlation Coefficient
S&P500 S&P 500 1.00 S&P 500 Domestic small stocks 0.68 S&P 500 Foreign stocks 0.60 S&P500 Real estate stocks 0.44 S&P 500 Treasury bonds 0.21 S&P 500 Gold stocks 0.30 — Source: www.seekingalpha.com.
EXHIBIT 5.3 Correlations Among Selected Investments
186 Understanding Healthcare Finance Management
EXHIBIT 5.4 Portfolio Size
and Risk
portfolios made up of any type of investment, including healthcare providers that offer many different types of services.
The riskiness inherent in an average one-investment portfolio is rela- tively high, as measured by the standard deviation of annual returns. The average two-investment portfolio has a lower standard deviation, so an aver- age two-investment portfolio is less risky than a single investment of average risk. The average three-investment portfolio has an even lower standard deviation of returns, so an average three-investment portfolio is even less risky than an average two-investment portfolio. As more investments are ran- domly added to create larger portfolios, the average riskiness of the portfolio decreases. However, as more and more investments are added, the incremen- tal risk reduction of adding even more assets decreases. Regardless of how many investments are added, some risk remains in the portfolio.5
The rationale for investors’ inability to eliminate all risk, even when holding very large portfolios, is worth repeating: All risk cannot be elimi- nated because the returns on the component investments are positively correlated with one another (although not perfecdy so). In other words, all investments, both real and financial, are affected to a greater or lesser extent by overall economic conditions.
Diversifiable Risk Versus Portfolio Risk Exhibit 5.4 shows what happens as investors create ever larger portfolios. As the size of a randomly created portfolio increases, the riskiness of the
portfolio decreases. Thus, a large proportion of the stand-alone risk inher- ent in an individual investment can be eliminated if it is held as part of a large portfolio. For example, if a stock investor wanted to eliminate as much stand-alone risk as possible, he would have to own more than 6,500 stocks. Fortunately, it is not necessary to purchase all the stocks individually because mutual funds that mimic all of the major stock indexes are available.6
A portfolio that consists of a large number of stocks is called the market portfolio because it consists of the entire stock market, or at least one entire segment of the stock market. Studies have found that the market portfolio has only about one-half the standard deviation of an average stock. However, it is not necessary for individual investors to own the market portfolio to take advantage of the risk-reducing benefits of diversification. As illustrated in Exhibit 5.4, most of the benefit can be obtained by holding about 50 randomly selected stocks. Such a collection of investments is called a well-diversified portfolio.
The part of the stand-alone riskiness of a single investment that can be eliminated by diversification (i.e., by holding it as part of a well-diversified portfolio) is called diversifiable risk. The part of the riskiness of a single invest- ment that cannot be eliminated by diversification is called portfolio risk. Every investment—whether it is the stock of Tenet Healthcare held by an individual investor or an MRI system operated by a hospital—has some diversifiable risk that can be eliminated and some portfolio risk that cannot be diversified away. Diversifiable risk, as seen by individuals who invest in stocks, is caused by events that are unique to a single business, such as new product or service introductions, strikes, and lawsuits. Because these events are essentially ran- dom and influence only one business, their effects can be eliminated by diver- sification. When one stock in a portfolio does worse than expected because of a negative event unique to that firm, another stock in the portfolio will do better than expected because of a positive event unique to that firm. On average, bad events in some firms will be offset by good events in others, so lower-than-expected returns will be offset by higher-than-expected returns, leaving the investor with an overall portfolio return closer to that expected than would be the case if only a single stock were held. The stand-alone risk of an investment can be broken down into two parts:
Key Equation 5.5: Diversifiable Versus Portfolio Risk
Stand-alone risk = Diversifiable risk + Portfolio risk.
Diversifiable risk is that portion of the stand-alone risk of an invest- ment that can be eliminated by placing it in a well-diversified portfolio, while Portfolio risk is the risk that remains (cannot be diversified away).
188 Understanding Healthcare Finance Management
The same logic can be applied to a business with a portfolio of proj ects. Perhaps hospital returns genr^ed from inpatient surgery are less than expected because of the trend toward outpatient procedures, but these lower returns may be offset by greater-than-expected returns generated from the delivery of state-of-the-art diagnostic services. (If the hospital offered both inpatient and outpatient surgery, it would be hedging itself against the trend toward more outpatient procedures because reduced demand for inpatient surgery would be offset by increased demand for outpatient surgery.)
The main point here is that the negative impact of random events that are unique to a particular firm, or to a firm’s product or service, can be offset by positive events in other firms or in other products or services. Thus, the risk caused by random, unique events can be eliminated by portfolio diver- sification. Individual investors can diversify by holding many securities, and businesses can diversify by operating many projects.
Note that not all investments benefit to the same degree from port- folio risk-reducing effects. Some have a large amount of diversifiable risk and hence experience a great deal of risk reduction when added to a well- diversified portfolio. Others do not benefit nearly as much from portfolio risk reduction. For example, consider adding the stock of Tenet Healthcare, a hospital management company, to two portfolios. The first portfolio consists of the stocks of 50 healthcare providers. The second portfolio consists of the stocks of 50 randomly selected firms from many different industries. Much less risk reduction will occur when the Tenet stock is added to the healthcare provider portfolio than when it is added to the randomly selected portfolio because Tenet’s returns are more highly correlated with healthcare providers than with firms in other industries. In other words, the lower the correlation, the greater the risk reduction.
This logic tells us there is more risk reduction inherent in adding a nursing home to a hospital business than there is in adding it to a long-term care firm that already owns a large number of such investments. Recognize, however, that managing a nursing home is probably more difficult for man- agers of a hospital business than for managers of a firm that specializes in long-term care.
Unfortunately, not all risk can be diversified away. Portfolio risk—the risk that remains even in well-diversified portfolios—stems from factors (such as wars, inflation, recessions, and high interest rates) that systematically affect all stocks in a portfolio or all products or services produced by a business. For example, the increasing power of managed care organizations or govern- mental payers could lower reimbursement levels for all services offered by a hospital. Because the portfolio risk inherent in single investments cannot be eliminated, even well-diversified investors—whether they are individuals with
large securities portfolios or diversified healthcare businesses with many dif- ferent service lines—face a considerable amount of risk.
Implications for Investors The ability to eliminate a portion of the stand-alone riskiness inherent in indi- vidual investments has two significant implications for investors—whether the investor is an individual who holds securities or a business that offers products or services:
1. Holding a single investment is not rational. Holding a portfolio can eliminate much of the stand-alone riskiness inherent in individual investments. Investors who are risk averse should seek to eliminate all diversifiable risk. Individual investors can easily diversify their personal investment portfolios by buying many individual securities or mutual funds that hold diversified portfolios. Businesses cannot diversify their investments as easily as individuals can, but businesses that offer a diverse line of products or services are less risky than businesses that rely on a single product or service.
2. Because an investment held in a portfolio has less risk than an investment held in isolation, the traditional stand-alone risk measure of standard deviation is not appropriate for individual assets when they are held as parts of portfolios. Thus, it is necessary to rethink the definition and measurement of financial risk for such assets. (Note, though, that standard deviation remains the correct measure for the riskiness of an investor’s portfolio because the portfolio is, in effect, a single asset held in isolation.)
1. What is a portfolio of assets? 2. What is a well-diversified portfolio? 3. What happens to the risk of a single investment when it is held as
part of a portfolio of assets? 4. Explain the differences between stand-alone risk, diversifiable risk,
and portfolio risk. 5. Why should all investors hold well-diversified portfolios rather
than individual assets? 6. Is standard deviation the appropriate risk measure for an individual
asset? 7. Is standard deviation the appropriate risk measure for an investor’s
portfolio of assets? Explain your answer.
SELF-TEST QUESTIONS
190 Understanding Healthcare Finance Management
Portfolio Risk of Business Investments
Businesses typically offer myriad different products or services and thus can be thought of as engaging in a large number (hundreds or even thousands; of individual activities. For example, most HMOs offer healthcare services to a large number of diverse groups of enrollees in numerous service areas and many hospitals and hospital systems offer a large number of inpatient outpatient, and even home health care services that cover a wide geographic area and treat a wide range of illnesses and injuries. Thus, healthcare manag- ers operate a portfolio of individual products or services, or projects. Fur- thermore, when investors buy the stock of a for-profit healthcare business, they are buying a portfolio of individual projects. A portfolio of 50 or more healthcare stocks is really a portfolio of tens of thousands of individual proj- ects run by the firms whose stocks are held in the portfolio.
From this description, it is obvious that individual projects under- taken by investor-owned businesses reside in two different portfolios. First, a project is part of the business’s overall portfolio of projects. For example, the Women’s Center at North Florida Regional Medical Center is just one of thousands of projects that make up HCA’s portfolio of projects. Second, a project is a small part of stockholders’ well-diversified portfolios of secu- rity investments. Investors who own Tenet Healthcare stock own the Coral Gables Hospital along with thousands of other Tenet projects, plus tens of thousands of projects owned by other firms in their stock portfolios.
Thus, the relevant portfolio risk of a business project depends on one’s perspective. A healthcare manager sees project riskiness from the standpoint of the business’s portfolio of projects, while a stock investor sees the riskiness inherent in holding the project as part of a well-diversified stock portfolio. Because the context is different for each portfolio, the riskiness of a given project is also different. In the next sections, these two types of portfolio risk are discussed in detail.
Corporate Risk: The Risk to Businesses To begin, put your manager’s hat on. What is the riskiness of a project to a
business? Because the project is part of the business’s portfolio of assets, its diversifiable risk is eliminated and stand-alone risk is not relevant. Rather, the relevant risk of a project to the business is its contribution to the business’s overall risk, or the impact of the project on the variability of the business’s overall rate of return. Some of the stand-alone riskiness of the project will be diversified away by combining the project with the business’s other projects. The remaining portfolio risk, which uses the business’s portfolio of projects as the benchmark, is called corporate risk.
For an illustration of corporate risk, assume that Project P represents expansion into a new service area by AtlantiCare, a for-profit HMO with
Chapter 5: Financial Risk and Required Return 191
many existing projects. Exhibit 5.5 contains the estimated rate of return dis- tributions for Project P and for AtlantiCare as a whole. AtlantiCare’s rate of return, like that of Project P, is uncertain and depends on future economic events. Overall, AtlantiCare’s expected rate of return is 7 percent, with a standard deviation of 2 percent and a coefficient of variation of 0.3. Thus, looking at either the standard deviation or the coefficient of variation (stand- alone risk measures), Project P is riskier than the HMO in the aggregate— that is, Project P is riskier than AtlantiCare’s average project.
However, the relevant risk of Project P is not its stand-alone risk but rather its contribution to AtlantiCare’s overall riskiness. Project P’s corporate risk depends not only on its standard deviation of returns but also on the correlation between the returns on Project P and the returns on the HMO’s average project (i.e., AtlantiCare’s rate of return distribution). If Project P had a negative correlation coefficient, signifying its returns were negatively correlated with the returns on AtlantiCare’s other projects, accepting the project would reduce the riskiness of the HMO’s aggregate returns. Further- more, the larger Project P’s standard deviation, the greater the risk reduction. (An economic state that results in a low return on AtlantiCare’s average proj- ect would produce a high return on Project P, and vice versa, so the returns would offset one another and AtlantiCare’s overall risk would be reduced.) In such a situation, Project P would actually have negative risk relative to the HMO’s average project, despite its high stand-alone risk. In actuality, how- ever, Project P’s returns are positively correlated with AtlantiCare’s aggregate returns, and the project has twice the standard deviation, so accepting it would increase the risk of AtlantiCare’s aggregate returns.
The quantitative measure of a project’s corporate risk is its corporate beta, or corporate b, which is the slope of the regression (scatter plot) line that results when the project’s returns are plotted on the Y-axis and the returns on the firm’s average project are plotted on the X-axis. Exhibit 5.6 shows this regression line, which is called the corporate characteristic line, for Project P.
Rate of Return
State of the Economy Probability of Occurrence ProjectP AtlantiCare
EXHIBIT 5.5 Estimated Return
Very poor 0.05 2.5% 1.0% Distributions Poor Average Good
0.20 0.50 0.20
5-o 10.0 15.0
6.0 7.0 8.0
for Project P and AtlantiCare
Very good 0.05 17-5 13.0
Expected return 10.0% 7.0% Standard deviation 4.0% 2.0% Coefficient of variation 0-3 Correlation coefficient
0.4 0.80
192 Understanding Healthcare Finance Management
The slope (rise over run) of Project P’s corporate characteristic line, which is Project P’s corporate beta coefficient, is about 1.60, and it can be found algebraically as follows:
Corporate bp = (op / cp) x rpp
where
op = standard deviation of Project P’s returns, OF = standard deviation of AtlantiCare’s returns (F stands for “firm”), and rpF = correlation coefficient between the returns on Project P and Atlanti- Care’s returns.
Thus,
Corporate bp = (4.0% / 2.0%) x 0.80 = 1.60.
A project’s corporate beta measures the volatility of returns on the project relative to the firm as a whole, or relative to the firm’s average project, which has a corporate beta of 1.0. (To estimate the corporate beta of
EXHIBIT 5.6 Corporate
Characteristic Line for
Project P
Project Return s
Chapter 5: Financial Risk and Required Return 193
the business’s average project, the business’s aggregate returns are plotted on both the X and Y axes, so the resulting slope of the corporate characteristic line is 1.0.)
If a project’s corporate beta is 2.0, its returns are twice as volatile as the business’s returns. Thus, if economic events lead to a 10 percent decrease in the business’s profitability, the profitability of a project with a corporate beta of 2.0 would be expected to fall by 20 percent. Because of the higher relative volatility, adding such a project to the business would increase the overall volatility of the business’s returns and hence would raise the riskiness of the business. A corporate beta of 1.0 indicates that the project’s returns have the same volatility as the business, so taking on the project would add identical risk to the business’s existing projects. A corporate beta of 0.5 indicates that the project’s returns are less volatile than the business’s returns, so taking on the project would lower the overall risk of the business.
Finally, a negative corporate beta, which results when a project’s returns are negatively correlated with the business’s returns, indicates that the project’s returns move countercyclical to the business’s returns. The addition of such a project to the business’s portfolio of projects can reduce a firm’s riskiness by a large amount (if the project is large enough). However, such projects are uncommon because most projects are in a single line of business, or in related lines, so their returns are positively correlated.
With a corporate beta of 1.6, the returns on Project P are 1.6 times as volatile as the returns on AtlantiCare’s average project. Thus, adding Project P to AtlantiCare’s portfolio of projects would increase the risk of the HMO, and Project P would be judged to have more corporate risk than AtlantiCare’s average project. Note that Project P’s stand-alone risk is twice that of AtlantiCare (op = 4 percent versus cy = 2 percent). However, Project P’s corporate (portfolio) risk is only 1.6 times as much (bp =1.6 versus bF = 1.0), so a large amount of Project P’s stand-alone risk has been eliminated by portfolio effects.
Market Risk: The Risk to Owners (Stockholders) The previous section discussed the portfolio risk of projects as seen by the business. This section discusses the portfolio risk of projects as seen by the owners (i.e., stockholders, if the business is a corporation) of a for-profit busi- ness. Why should a healthcare manager be concerned about how a business’s owners view risk? The answer is simple: Stock investors are the suppliers of equity capital to investor-owned businesses, so they set the rates of return that these businesses must pay to raise equity capital. These rates, in turn, set the minimum profitability that investor-owned businesses must earn on the equity portion of their real asset investments. Even managers of not-for-profit firms should understand how stock investors view risk because market-set
194 Understanding Healthcare Finance Management
required rates of return can play a role in estimating the opportunity co inherent in not-for-profit businesses. (We have much more to say about this subject in Chapter 9.)
Because stock investors hold well-diversified portfolios of stocks the relevant riskiness of an individual project undertaken by a business whose stock is held in the portfolio is its contribution to the overall riskiness of the portfolio. Thus, the riskiness of the Women’s Center at North Florida Regional Medical Center to an individual investor who has a portfolio of 5o stocks, to a trust officer who manages a 150-stock portfolio, or to a 500- stock mutual fund owner is the contribution that the project makes to the riskiness of the overall stock portfolio. Some of the stand-alone risk of the project will be diversified away by combining the project with all the other projects in the stock portfolio. The remaining portfolio risk is called market risk, which is defined as the contribution of a project to the riskiness of a well-diversified stock portfolio.
How should a project’s market risk be measured? A project’s market beta, or market b, measures the volatility of the project’s returns relative to the returns on a well-diversified stock portfolio. Exhibit 5.7 contains hypo- thetical estimates of the rate of return on a well-diversified portfolio of stocks, which is commonly called a market portfolio, or just market, along with the returns on AtlantiCare’s Project P. In practice, some stock index—for example, the S&P 500 Index or the NYSE Index—is used as a proxy for the market portfolio. (The S&P 500 is an index made up of 500 stocks across many industries, while the NYSE Index is made up of the roughly 2,800 common stocks listed on the NYSE.)
The market beta of Project P is found by constructing the market characteristic line for the project, which is the regression (scatter plot) line that results from plotting the returns on Project P against the returns on the
EXHIBIT 5.7 Estimated
Return Distributions for Project P
and the Market
Rate of Return
State of the Economy Probability of Occurrence ProjectP Market
Very poor 0.05 2.5% -15.0% Poor 0.20 5-0 5-o Average 0.50 10.0 15.0 Good 0.20 15.0 25.0 Very good 0.05 17.5 45-0
Expected return 10.0% 15.0% Standard deviation 4.0% 11.4% Coefficient of variation 0.4 0.8 Correlation coefficient 0-94
Chapter 5: Financial Risk and Required Return 195
market. Project P’s market characteristic line, which is shown in Exhibit 5.8, has a slope of 0.33; hence, Project P’s market beta is 0.33.
Note that Project P’s market beta can be calculated as follows:
Market bp = (op / oM) x rpM,
where
op = standard deviation of Project P’s returns,
oM = standard deviation of the market’s returns, and
rpM = correlation coefficient of returns between Project P and the market.
Thus, using the data from Exhibit 5.7,
Market bp = (4.0% / 11.4%) x 0.94 = 0.33.
Project P’s market beta measures its market risk, which is the risk relevant to AtlantiCare’s well-diversified shareholders. Intuitively, a project’s market beta measures the volatility of the project’s returns relative to the
Project Returns
EXHIBIT 5.8 Market Characteristic Line for Project P
196 Understanding Healthcare Finance Management
returns on a well-diversified portfolio of stocks (the market portfolio), which has a beta of 1.0.
A project with a market beta of 2.0 has returns that are twice as volatile as the returns on the market, so adding it to a well-diversified portfolio will increase the portfolio’s risk. A market beta of 1.0 indicates that the project’s returns have the same volatility as the market, so adding such a project would have no impact on the riskiness of the market portfolio. A market beta of 0 5 indicates that the project’s returns are half as volatile as the returns on the mar- ket, so adding such a project to a well-diversified portfolio would reduce its risk
With a market beta of 0.33, Project P has only one-third the riskiness inherent in the market portfolio, and its acceptance by the HMO would reduce the riskiness of shareholder portfolios. (As you will see shortly, the beta of a portfolio is merely the weighted average of the betas of the indi- vidual components of the portfolio. Thus, adding a component with a lower beta than the portfolio average lowers the beta of the portfolio and hence lowers the riskiness of the portfolio.)
As in our discussion of corporate risk, a negative market beta indicates that the returns on the project move counter-cyclically to the returns on the market: When the market’s return goes up, the project’s return goes down, and vice versa. Negative beta projects are valuable to stockholders because of their risk-reduction characteristics. However, negative market beta projects are rare because most projects’ returns, as well as the market’s returns, are positively correlated with the economy as a whole.
Note that Project P’s stand-alone risk is about 35 percent of that of the market (op = 4 percent versus OM =11.4 percent). However, Project P’s portfolio (market) risk is 33 percent as much as the market (bp = 0.33 versus bM = 1.0), so only a small amount of Project P’s stand-alone risk has been eliminated by portfolio effects.7
SELF-TEST QUESTIONS 1. A project in a for-profit business is held as part of what two
portfolios? 2. How is corporate risk defined? 3. What is a corporate beta, and how is it determined? 4. How is market risk defined? 5. What is a market beta, and how is it determined?
Portfolio Risk of Stocks (Entire Businesses)
Even though an individual investor’s stock portfolio can be thought of as a portfolio of many separate projects, the portfolio actually consists of the stocks
Chapter 5: Financial Risk and Required Return 197
of firms, so individual investors are most concerned with the aggregate risk and return characteristics of the firms themselves. Thus, individual investors are concerned with the stock’s market beta rather than with the market betas of individual projects. A stock’s market beta is the slope of the market characteristic line formed by regressing the business’s aggregate returns against market returns, for example, using the data in exhibits 5.5 and 5.7, we find AtlantiCare’s market beta to be 0.17. Because the average stock has a market beta of 1.0, AtlantiCare’s market beta is very low, and adding the stock of AtlantiCare to a well-diversified portfolio would tend to lower the overall riskiness of the portfolio.
When individual investors assess the riskiness of individual stocks, the relevant measure is the stock’s market beta, and the reference value is the market portfolio’s overall beta of 1.0. When investor-owned firms conduct project market-risk analyses, managers want to know how the project’s mar- ket risk compares to the market risk of the firm’s average project. This deter- mination is made by comparing the project’s market beta to the business’s market beta. Our illustrative Project P, with a market beta of 0.33, has signifi- cantly more market risk than AtlantiCare’s average project, which has a mar- ket beta of 0.17. Thus, although the market risk of Project P is low, it is high relative to the market risk of the entire business.
1. What is the difference between a project’s market beta and the business’s, or stock’s, market beta?
SELF-TEST QUESTION
Portfolio Betas
Individual investors hold portfolios of stocks, each with its own market risk as measured by the stock’s market beta coefficient, while businesses hold portfolios of projects, each with its own corporate and market betas. What impact does the beta of a portfolio component have on the overall portfolio’s beta? The beta of any portfolio of investments is simply the weighted average of the individual investments’ betas:
Key Equation 5.6: Portfolio Beta Portfolio = (W1 x bi) + (w2 x b2) + (w3 x b3) + (w_ X b) and so on.
Here, bportfo|io is the beta of the portfolio, which measures the volatil- !ty of the entire portfolio; w. is the fraction of the portfolio invested in each particular asset; and b. is the beta coefficient of that asset.
198 Understanding Healthcare Finance Management
For an illustration of this concept, consider the following example Tenet Healthcare Corporation might have a market beta of 1.2, which indi- cates that the returns on its stock are slightly more volatile than the returns on a well-diversified portfolio (the market portfolio with a beta of l.Q) Hence, the stock is somewhat riskier than the average stock, but each project within Tenet has its own market risk, as measured by each project’s market beta. Some projects may have very high market betas—for example, over 1.5—while other projects may have very low market betas—say, under 0.5 When all of the projects are combined, the overall market beta of the firm is 1.2. For ease of illustration, assume that Tenet has only the following three projects:
Project Market Beta Dollar Investment Proportion
A 0.5 $ 15,000 15.0% B 1.0 30,000 30.0 C 1.5 55,000 55.0
$100,000 100.0%
The weighted average of the project market betas, which is the firm’s market beta, is 1.2:
bportfolio = (°-15 x °-5) + (°-30 X 1.0) + (0.55 X 1.5)
= 1.20.
Note that each project within Tenet’s fictitious portfolio of three proj- ects also has a corporate beta that measures the volatility of the project’s returns relative to that of the overall business. The weighted average of these project corporate betas must equal 1.00, which is the corporate beta of any business.
SELF-TEST QUESTION 1. How is the beta of a portfolio related to the individual betas of
the investments that make up the portfolio?
Relevance of the Risk Measures
Thus far, this chapter has discussed in some detail three measures of financial risk—stand-alone, corporate, and market—but it is still unclear which risk is the most relevant in financial decision making. It turns out that the risk that is relevant to any financial decision depends on the situation. When the decision
Chapter 5: Financial Risk and Required Return 199
involves a single investment that will be held in isolation, stand-alone risk is rhe relevant risk. Here, the risk and return on the portfolio is the same as the risk and return on the single asset in the portfolio. In this situation, the riskiness faced by the investor, whether the investor is an individual consider- ing a stock purchase or a business considering an MRI system investment, is defined in terms of returns that are less than expected, and the appropriate measure is the standard deviation or coefficient of variation of the return distribution.
In most decisions, however, the investment under consideration will not be held in isolation but rather will be held as part of an investment portfolio. Individual investors normally hold portfolios of securities, while businesses normally hold portfolios of real asset investments (projects). Thus, portfolio risk is more relevant to real-world decisions than is stand-alone risk. However, there are three distinct ownership situations that affect the relevancy of portfolio risk.
Large Investor-Owned Businesses For large investor-owned businesses, the primary financial goal is shareholder
wealth maximization, which means that managerial decisions should focus on risk and return as seen by the business’s stockholders. Because stockholders tend to hold large portfolios of securities and hence very large portfolios of individual projects, the most relevant risk of a project under consideration by a large for-profit firm is the project’s contribution to a well-diversified stock portfolio (the market portfolio). Of course, this contribution is the project’s market risk. Many would argue, and we agree, that corporate and stand- alone risk cannot be disregarded in all situations. For example, corporate risk—which best measures the impact of the project on the financial condi- tion of the business—is relevant to the business’s other stakeholders, such as managers, employees, creditors, and suppliers, who should not be ignored. Also, the failure of a project that is large relative to the business can bring down the entire firm. Under such circumstances, the project has high risk to stockholders even if its market risk is low. The bottom line here is that market risk should be of primary importance in large investor-owned businesses, but corporate and stand-alone risk should not be totally ignored.
Small Investor-Owned Businesses For small investor-owned businesses, the situation is more complicated. Take, for example, a three-physician group practice. Here, there is no separation between management and ownership, and the equity investment position is complicated by the fact that the business is also the owners’ employer. In this situation, the primary goal of the business is more likely to be maximiza- tion of the owners’ overall well-being rather than strict shareholder wealth
200 Understanding Healthcare Finance Management
maximization. For example, owner/managers may value leisure time, such as three afternoons of golf, over additional wealth creation. To complicat the situation even more, shareholder wealth consists of both the value of the ownership position and the professional fees (salaries) derived from the business.
Thus, in small for-profit businesses, corporate risk is probably more relevant than market risk. The owner/managers would not want to place the viability of the business in jeopardy just to increase their expected own- ership value by a small amount. Put another way, the owner/managers are not well diversified in regards to the business because a large proportion of their wealth comes from future employment earnings. As a result, market risk loses relevance and corporate risk becomes most important. However, the potential relevancy of stand-alone risk as described in the previous section also applies.
Not-for-Profit Businesses Not-for-profit businesses do not have owners, and their goals stem from a mission statement that usually involves service to society. In this situation, market risk is not relevant; the managers’ concern is the impact of the project on the riskiness of the business, which is measured by a project’s corporate risk. Thus, the risk measure most relevant here is corporate risk. Again, how- ever, the stand-alone risk of large projects that can sink the business is relevant.
SELF-TEST QUESTION 1. Explain the situations in which each type of risk—stand-alone,
corporate, and market—is relevant.
Interpretation of the Risk Measures
None of the risk measures discussed can be interpreted without some stan- dard of reference. For example, if we are focusing on stand-alone risk, does Project P’s coefficient of variation of returns of 0.4 indicate high risk, low risk, or moderate risk? We cannot answer this question without more infor- mation. However, knowing that AtlantiCare in the aggregate has a coeffi- cient of variation of returns of 0.3 enables us to state that Project P has more stand-alone risk than the HMO’s average project has.
Similarly, Project P’s corporate beta of 1.6, when compared to Atlanti- Care’s overall corporate beta of 1.0 (by definition), indicates that the project has above-average corporate risk. Similarly, Project P’s market beta of 0.33, when compared to AtlantiCare’s market beta of 0.17, indicates that the
project has above-average market risk as compared to the entire business. The point to remember is that, in practice, risk is always interpreted against some standard because without a standard it is impossible to make judgments.
Which risk is most relevant to AtlantiCare? As discussed in the previ- ous section, market risk is most relevant because AtlantiCare is a large inves- tor-owned business; hence, managers should be most concerned about the impact of new projects on stockholders’ risk. With a market beta of 0.17, Project P’s relevant (market) risk is much less than the average (b = 1.0) risk borne by AtlantiCare’s well-diversified stockholders, so the project’s market risk is quite low.
1. How are risk measures interpreted? SELF-TEST QUESTION
The Relationship Between Risk and Return
This chapter contains a great deal of discussion on defining and measuring financial risk. However, the ability to define and measure financial risk is of no value in financial decision making unless risk can be related to return— that is, the answer to this question is needed: How much return is required to compensate investors for assuming a given level of risk? In this section, we focus on setting required rates of return on stock investments because the basic theory of risk and return was developed for stock investments. In later chapters, the focus is on setting required rates of return on individual projects within firms.
On the web at: ache.org/books/ UHFM7
The relationship between the market risk of a stock, as measured by its market beta, and its required rate of return is given by the capital asset pricing model (CAPM). To begin, some basic definitions are needed:
• E(R.) = Expected rate of return on Stock i, any stock. • R(R.) = Required rate of return on Stock i. If E(R) is less than R(K),
the stock should not be purchased or should be sold if it is owned. If E(R) is greater than R(R), the stock should be bought, and an individual should be indifferent about the purchase if E(R.) = R(R.).
• RF = Risk-free rate of return. In a CAPM context, RF is generally measured by the return on long-term US Treasury bonds (T-bonds).
• b. = Market beta coefficient of Stock i. The market beta of an average- risk stock is bA = 1.0.
• R(RM) = Required rate of return on a portfolio that consists of all stocks, which is the market portfolio. R(RM) is also the required rate of return on an average (bA = 1.0) stock.
202 Understanding Healthcare Finance Management
• RPM = Market risk premium = R(RM) - RF. This is the additional return over the risk-free rate required to compensate investors for assuming average (bA = 1.0) risk.
• RPi = Risk premium on Stock i = [R(RM) - RF] x b. = RPM x b.. Stock i’s risk premium is less than, equal to, or greater than the premium on an average stock, depending on whether its beta is less than, equal to or greater than 1.0. If b. = bA = 1.0, then RP. = RPM.
Using these definitions, the CAPM relationship between risk and required rate of return is expressed by the following equation, which specifies a line called the security market line (SML):
Key Equation 5.7: Security Market Line (SML)
R(K) = RF + (R[RJ - RF) x b
= RF + (RPM x b).
For an illustration of the use of the SML, assume that the risk-free rate (RF) is 6 percent; the required rate of return on the market, R[RM], is 10 percent; and the market beta of Regis Healthcare is 1.1. According to the SML, the required rate of return on Regis stock is 10.4 percent:
If the expected rate of return, E(RRegis), is 15 percent, investors should buy the stock because E(RRegis) is greater than R(RRcgis). Conversely, if the expected rate of return is E(RRcgis) = 8 percent, investors should sell the stock because E(RRegis) is less than R(RRcgis).
A stock with a beta of 2.0, one that is riskier than Regis, would have a required rate of return of 14 percent:
R(Rb = 20) = 6% + (4% x 2.0)
= 6% + 8% = 14%,
while an average stock, with b. = 1.0, would have a required return of 10 percent, which is the same as the market return:
Chapter 5: Financial Risk and Required Return 203
R(Rb = 10) = 6% + (4% x 1.0) = 6% + 4% = 10% = R(RM).
A stock with below-average risk—for example, b. = 0.5—would have a required return of 8 percent:
R(Rb = 0S) = 6% + (4% x 0.5)
= 6% + 2% = 8%.
The market-risk premium, RPM, depends on the degree of aversion that investors in the aggregate have to risk. In this example, T-bonds yielded an RF of 6 percent, and an average share of stock had a required rate of return (R(RM)) of 10 percent, so RPM is 4 percentage points. If the degree of risk aversion increased, R(RM) might increase to 12 percent, which would cause RPM to increase to 6 percentage points. Thus, the greater the overall degree of risk aversion, the higher the required rate on the market and hence the higher the required rates of return on all stocks.
Also, values for the risk-free rate, RF, and the required rate of return on the market, R(RM), arc influenced by inflation expectations. The higher the expectations of investors regarding inflation, the greater these values and hence the greater the required rates of return on all stocks.
The SML is often depicted in graphical form, as in Exhibit 5.9, which shows the SML when RF = 6 percent and R(RM) = 10 percent. Here are the relevant points concerning the graph:
• Required rates of return are shown on the vertical axis, while risk as measured by market beta is shown on the horizontal axis.
• Riskless securities have b. = 0; therefore, RE is the vertical axis intercept. • The slope of the SML reflects the degree of risk aversion in the
economy. The greater the average investor’s aversion to risk, (1) the steeper the slope of the SML, (2) the greater the risk premium for any stock, and (3) the higher the required rate of return on stocks.
• The Y-axis intercept reflects the level of expected inflation. The higher inflation expectations are, the greater both RF and R(RM) are and thus the higher the SML plots on the graph.
• The values previously calculated for the required rates of return on stocks with b. = 0.5, b = 1.0, and b. = 2.0 agree with the values shown on the graph.
Both the SML and a firm’s position on it change over time because of changes in interest rates, investors’ risk aversion, and individual firms’ betas.
204 Understanding Healthcare Finance Management
EXHIBIT 5.9
The Security Market Line
Thus, the SML, as well as a firm’s risk, must be evaluated on the basis of cur- rent information. The SML, its use, and how its input values are estimated are covered in greater detail in Chapter 9.
SELF-TEST QUESTIONS 1. What is the CAPM?
2. What is the appropriate measure of risk in the CAPM? 3. Write out the equation for the SML, and graph it. 4. How do changes in risk aversion and inflation expectations affect
the SML?
Some Thoughts About Beta and the CAPM
The CAPM is more than just an abstract theory described in textbooks. It is widely used by analysts, investors, and corporate managers. However, despite its intuitive appeal, a number of serious concerns surround the CAPM:
1. It is built on a restrictive set of assumptions that does not conform well to real-world conditions.
2. It is impossible to prove. Studies that do demonstrate the linear relationship between market risk and required return prove nothing
Chapter 5: Financial Risk and Required Return 205
because the results stem from the mathematical properties of the model and not because it is theoretically correct.
3. Some studies find no relationship between stocks’ returns and market betas.
4. The market betas that are actually used in the CAPM measure the historical relative volatility of a stock but conditions often change. Thus, its future volatility, which is of real concern to investors, might be quite different from its past volatility.
Despite these concerns, the CAPM is extremely appealing because it is simple and logical. It focuses on the impact that a single investment has on a portfolio, which in most situations is the correct way to think about risk. Fur- thermore, it tells us that the required rate of return on an investment is com- posed of the risk-free rate, which compensates investors for time value, plus a risk premium that is a function of investors’ attitudes toward risk bearing in the aggregate and the specific portfolio risk of the investment being evaluated. Because of these points, the CAPM is an important conceptual tool. However, its actual use to set required rates of return must be viewed with some caution. We have more to say about this topic in Chapter 9.
1. What are the pros and cons regarding the CAPM? SELF-TEST QUESTION
Chapter Key Concepts This chapter has covered the important concepts of financial risk and
return. Here are its key concepts:
• Risk definition and measurement are important in financial management because, in general, decision makers are risk averse and hence require higher returns from investments that have higher risk.
• Financial risk is associated with the prospect of returns that are less than anticipated. The higher the probability that the return will be far less than anticipated, the greater the risk.
• The riskiness of investments held in isolation, called stand-alone risk, can be measured by the dispersion of the rate of return distribution about its expected value. One commonly used measure of stand- alone risk is the standard deviation of the return distribution.
(continued)
206 Understanding Healthcare Finance Management
(continued from previous page) • Most investments are not held in isolation but rather as part of
portfolios. Individual investors hold portfolios of securities, and businesses hold portfolios of projects (i.e., products and services)
• When investments with returns that are less than perfectly positively correlated are combined in a portfolio, risk is reduced. The risk reduction occurs because less-than-expected returns on some investments are offset by greater-than-expected returns on other investments. However, among real-world investments, it is impossible to eliminate all risk because the returns on all assets are influenced by overall economic conditions.
• The portion of the stand-alone risk of an investment that can be eliminated by holding the investment in a portfolio is called diversifiable risk, while the risk that remains is called portfolio risk.
• There are two different types of portfolio risk. Corporate risk is the riskiness of business projects when they are considered parts of a business’s portfolio of projects. Market risk is the riskiness of business projects, or of the stocks of entire businesses, when they are considered parts of an individual investor’s well-diversified portfolio of securities.
• Corporate risk is measured by a project’s corporate beta, which reflects the volatility of the project’s returns relative to the volatility of returns of the aggregate business.
• Market risk is measured by a project’s, or stock’s, market beta, which reflects the volatility of a project’s, or stock’s, returns relative to the volatility of returns on a well-diversified stock portfolio.
• Stand-alone risk is most relevant to investments held in isolation; corporate risk is most relevant to projects held by not-for-profit businesses and by small investor-owned businesses; and market risk is most relevant to projects held by large investor-owned firms.
• The beta coefficient of a portfolio of investments is the weighted average of the betas of the components of the portfolio—the weights being the proportion of the overall investment in each component. Therefore, the weighted average of corporate betas of all projects in a business must equal 1.0, while the weighted average of all projects’ market betas must equal the market beta of the firm’s stock. • The capital asset pricing model (CAPM) is an equilibrium model
that describes the relationship between market risk and required rates of return.
207
9 The security market line (SML) provides the actual risk/required rate of return relationship. The required rate of return on any Stock i is equal to the risk-free rate plus the market-risk premium times the stock’s market beta coefficient: R(R.) = RF + (R(RM) - RF] x b = RF + (RPM x b).
This concludes our discussion of basic financial management con- cepts, which include time value analysis, financial risk, and required rate of return. In the next chapter—Debt Financing—we begin our coverage of capital acquisition.
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
• A chapter model that shows how to perform many of the calculations described in the chapter
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and that tests
your ability to perform the calculations in preparation for a case
These resources can be accessed on the book’s companion website at ache.org/books/UHFM7.
Selected Case
One case in Cases in Healthcare Finance, 5th edition, is applicable to this chapter:
• Case 13: Mid-Atlantic Specialty, Inc.
Selected Bibliography
Brigham, E. F., and P. R. Daves. 2012. “Chapters 2 and 3.” In Intermediate Finan-
cial Management, 11th ed. Mason, OH: South-Western Cengage Learning.
208 Understanding Healthcare Finance Management
Selected Websites
The following websites pertain to this chapter:
• For stock market (company) betas, see www.reuters.com/fmance. In the Search News & Quotes box on the top bar, enter the stock symbol of a firm (e.g., THC) and then click the magnifying glass. On the list of tabs beneath the company name, click Financials. The beta for the company is reported in a table along with other stock market data and financial ratios.
• Try Morningstar for information about the riskiness of mutual funds at www.morningstar.com. Click on Funds on the menu bar. Next, type in a fund symbol—for example, VFINX for the Vanguard 500 Index Fund—in the Quotes box, and then click on Quote. Finally, click on Risk Measures on the menu bar, which appears right below the fund name. The next screen will display several risk (volatility) measures, including standard deviation.
Notes
1. If inflation is considered, the T-bill investment is not truly risk free. The real return, which recognizes inflation effects, is uncertain because it depends on the amount of inflation realized over the year.
2. In markets that are efficient, low-risk investments will have low expected returns, while high-risk investments will have high expected returns. However, not all markets are efficient. See Chapter 7 for a complete discussion of market efficiency.
3. See Note 2. 4. A portfolio of two investments has lower risk than that of either
component only when the correlation coefficient between the returns on the two investments is less than the ratio of the standard deviations, when this ratio is constructed with the lower standard deviation in the numerator. For example, for Portfolio AD to have less risk than both A and D, the correlation coefficient between the returns on A and D must be less than = 11.0%/12.1% = 0.91. The actual correlation coefficient is 0.53, so the condition is met in this example.
5. Although stocks can be combined with complex investments (derivatives) to form riskless portfolios, our emphasis here is on real- assets investments.
209
6 The Wilshire 5000 Index, also called the Total Stock Market Index, mimics the returns of all publicly traded US stocks.
7 The amount of risk reduction that occurs when an investment is added to a portfolio is measured by the distance of the plot points from die characteristic line. The more the points plot away from the line, the greater the risk reduction when the investment is added to the portfolio. In other words, the distance of the plot points from the line measures the amount of diversifiable risk. In this illustration, the points are farther from the line in Exhibit 5.6 than in Exhibit 5.8, so more risk reduction occurs when Project P is added to the corporate portfolio than when it is added to the market portfolio.
210 Understanding Healthcare Finance Management 1 Integrative Application
The Problem
A patient of Greenacre Hospital recently made a substantial donation in grati- tude for the excellent care she received during a recent hospital stay. The money will be added to a board-designated fund that can be used only for cancer research. Gail Simmons is the chair of the investment committee of Greenacre’s board, which has been asked to invest the funds. The committee is consider- ing investment in two stocks: New Horizons Biotech (NHB) and Valley Nursing Homes (VNH). The returns of the two stocks and the market over the past five years are as follows:
Year NHB VNH Market
1 14% 13% 12% 2 19% 7% 10%
3 -16% -5% -12%
4 3% 1% 1% 5 20% 11% 15%
The risk-free rate is 6 percent, and the market risk premium is 5 percent. Gail has reviewed the recommendations of various financial advisors and the average expected return of NHB is 12 percent and of VNH is 10 percent. The com- mittee must decide whether to invest in NHB, VNH, or both stocks.
The Analysis
The =SLOPE function in Excel can be used to determine the betas:
NHB: b = 1.3471
VNH: b = 0.6508
The required rates of return are as follows:
NHB: R(Ri) = 6% + 5% (1.3471) = 12.7355%
VNH: R(Ri) = 6% + 5% (0.6508) = 9.2540%
211
The expected rates of return are as follows:
NHB: E(Ri) = 12% VNH: E(Ri) = 10%
The Decision
The committee decided to invest in VNH because its expected rate of return is greater than its required rate of return, whereas the expected rate of return of NHB is less than its required rate of return. ■
PART
CAPITAL ACQUISITION
Healthcare organizations need assets to provide services. For example,hospitals need facilities and equipment to provide inpatient and out-patient services, while clinics require similar (but somewhat different) assets to provide their services. To obtain these assets, healthcare organiza- tions need capital (money). A large hospital requires a very large amount of capital (some hospitals have more than $1 billion of capital), while a small home health business requires a relatively small amount of capital. Regardless of size, all healthcare organizations need capital to acquire the facilities, equipment, and other assets needed to run the business.
Many different types of capital are available to healthcare organi- zations. Debt financing is supplied by lenders, while equity financing is obtained from owners (in the case of for-profit businesses) and from the community at large (in the case of not-for-profit businesses). In addition to using traditional financing (debt and equity), healthcare organizations can obtain the use of facilities and equipment by leasing. Because different types of financing have different characteristics, managers must understand the dif- ferences between the types of capital and the impact of these differences on the financial condition of the business. Furthermore, to better understand how capital suppliers decide how much to charge for capital, managers need to know how securities are valued.
The three chapters in this section—chapters 6 through 8—introduce you to the types of capital available to healthcare organizations and the valu- ation of this capital in the marketplace.
CHAPTER
DEBT FINANCING 6 Learning Objectives After studying this chapter, readers should be able to
• describe how capital is allocated in the economy; • discuss the various types of debt—including both long term and
short term—and their features; • discuss credit ratings and their importance; • discuss the yield curve and the components that make up the
interest rate on a debt security; • describe how securities in general are valued; and • assess the value of debt securities and their yields to maturity.
Introduction
To operate, a business must have assets, and to acquire assets, it must raise capital. Capital comes in two basic forms: debt and equity. This chapter focuses on debt financing, while Chapter 7 focuses on equity financing. To illustrate the importance of debt financing to healthcare businesses, provid- ers, on average, finance their assets with roughly 5 percent short-term debt, 30 percent long-term debt, and 65 percent equity. Thus, more than one- third of providers’ financing comes from debt. In this chapter, many facets of debt financing are discussed, including important background information on how interest rates are set in the economy.
Unfortunately, the term debt can be interpreted in two ways. First, debt can refer to everything on the right side (lower section) of a balance sheet that is not equity, including interest-bearing debt and non-interest- bearing liabilities, such as accruals and trade credit (accounts payable). For some purposes, this all-inclusive definition is appropriate. Second, debt can refer only to interest-bearing debt supplied by creditors, such as banks and bondholders. For purposes of this chapter, we will use the second definition and confine our discussion to interest-bearing debt. Other types of liabili- ties specifically accruals and trade credit—are discussed in Chapter 15.
215
216 Understanding Healthcare Finance Management
There are many different types of debt with hundreds of different features. If we were to discuss all of the debt types and their features, this chapter would be too long to be manageable. Thus, the chapter focuses on key issues, while the Chapter 6 Supplement (see the end of this chapter) con- tains material that is useful and relevant but not essential to understanding the fundamentals of debt financing.
The Cost of Money
Capital in a free economy is allocated through the price system. The inter- est rate is the price paid to obtain debt capital, whereas in the case of equity capital in for-profit firms, investors’ returns come in the form of dividends and capital <gains (or losses'). The four most fundamental factors that affect the supply of and demand for investment capital, and hence the cost of money, are (1) investment opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation. To see how these factors operate, visualize the situation facing Lori Madison, a nurse-entrepreneur who is planning to start a new home health agency. Lori does not have sufficient personal funds to finance the business, so she must go to the debt markets to borrow additional capital.
Investment Opportunities If Lori estimates that the business will be highly profitable, she will be able to pay creditors a higher interest rate than if it is barely profitable. Thus, her ability to pay for borrowed capital depends on the business’s invest- ment opportunities: The higher the profitability of the business, the higher the interest rate that Lori can afford to pay lenders for use of their savings. In periods of tight credit, high-profitability businesses will be able to afford debt financing, while low-profitability businesses will not be able to pay the prevailing high level of interest rates.
Time Preferences for Consumption The interest rate that lenders will charge depends, in large part, on their time preferences for consumption. For example, one potential lender, Jane Adams, is saving for retirement, so she may be willing to loan funds at a relatively low rate because her preference is for future consumption. Another person, John Rittenhouse, has a wife and several young children to support, so he may be willing to lend funds out of current income, and hence forgo consumption, only if the interest rate is very high. John is said to have a high time prefer- ence for consumption and Jane a low time preference. If the entire popula- tion of an economy were living right at the subsistence level, time preferences for current consumption would necessarily be high, aggregate savings would
Chapter 6: Debt Financing
be low, interest rates would be high, and debt capital would be difficult to obtain.
Risk The risk inherent in the prospective home health care business, and thus in Lori’s ability to repay the loan, will also affect the return that lenders would require—the higher the perceived risk, the higher the interest rate. Investors are unwilling to lend to high-risk businesses unless the interest rate is higher than the rate on loans to low-risk businesses.
Inflation Finally, because the value of money in the future is affected by inflation, the higher the expected rate of inflation, the higher the interest rate lenders will demand. To simplify matters, the illustration implied that Jane and John would lend directly to businesses that need capital, but in most cases, the funds would pass through a financial intermediary, such as a bank or mutual fund.
1. What is the “price” of debt capital? 2. What four factors affect the cost of money?
SELF-TEST QUESTIONS
Long-Term Debt
One of the most important ways of categorizing debt is by maturity, or the length of the loan. In general, debt is categorized as long term or short term. Although the definitions of “long” and “short” depend on the type of debt under discussion, in most situations short-term debt is defined as having a maturity of one year or less, while long-term debt has a maturity of more than one year. Even when the focus is solely on long-term debt, there are still hundreds, if not more, of different types. In the following sections, we briefly discuss the types of debt most commonly used by healthcare businesses.
1. What is the difference between short-term debt and long-term debt?
SELF-TEST QUESTION
Term Loans
A term loan (short for long-term loan) is a contract under which a borrower agrees to make a series of payments, on specified dates, to the lender. These
218 Understanding Healthcare Finance Management
payments consist of principal (which is the amount borrowed) and interest (which is the return the lender receives from the borrower for use of the capital). In general, term loans are negotiated directly between the borrow- ing business and a financial institution—generally, a bank, a mutual fond, an insurance company, or a pension fond. Thus, term loans are private place- ments as opposed to public offerings, which are typically used on bonds—foe other major type of long-term debt.
Most term loans have maturities in the range of two to ten years, with an average of about four years. Term loans usually are amortized in equal installments over the life of the loan, so part of the principal of the loan is retired with each payment. For example, Sacramento Cardiology Group has a $100,000 five-year term loan with Bank of America to fond the purchase of new diagnostic equipment. The interest rate on the fixed-rate loan is 10 per- cent, which obligates the group to five end-of-year payments of $26,379.75. Thus, loan payments total $131,898.75, of which $31,898.75 is interest and $100,000 is repayment of principal.
Term loans have three major advantages over bonds (debt sold to foe general public): (1) speed, (2) flexibility, and (3) low issuance costs. Because term loans are negotiated directly between the lender and the borrower, formal documentation is minimized. The key provisions of the loan can be worked out much more quickly and with more flexibility than can those for a public issue, and it is not necessary for a term loan to go through a com- plicated registration process. A further advantage of term loans over publicly held debt is future flexibility. If many different investors hold a debt issue, it is virtually impossible to alter the terms of the agreement, even though new economic conditions may make such changes desirable. With a term loan, the borrower can generally negotiate with the lender to work out modifications in the contract.
The interest rate on a term loan can be fixed for the life of the loan or variable. If fixed, the rate will be close to the rate on bonds of equivalent maturity for firms of comparable risk. If variable, the rate usually will be set at a certain number of percentage points over an index rate, such as the prime rate.1 Then, when the index rate goes up or down, so does the rate on the outstanding balance of the term loan.
Although term loans have many advantages, there are two potential disadvantages. First, there is a limit to the size of a term loan. Although they can be large—such as when multiple banks combine to make a loan of $100 million or more—most term loans are relatively small, with an average of less than $1 million. Also, lenders typically will not extend term loans to the maturity that businesses can attain in a bond financing, which makes term loans inappropriate for use in financing assets with long lives, such as land and buildings.
Chapter 6: Debt Financing 219
SELF-TEST QUESTION
Bonds
Like a term loan, a bond is a long-term contract under which a borrower agrees to make payments of interest and principal to the holder of the bond ,the lender) on specific dates. Although bonds are similar in many ways to term loans, a bond issue generally is registered with the Securities and Exchange Commission (SEC); advertised; offered to the public in relatively small increments—say, $1,000 or $5,000—through investment bankers; and sold to many different investors (lenders). Indeed, thousands of individual and institutional investors may participate when a firm, such as Tenet Health- care, sells a bond issue, while there is generally only one lender in the case of a term loan.
Bonds are categorized as either government (Treasury), corporate, or municipal. Government, or Treasury, bonds are issued by the US Treasury and are used by the federal government to raise money.2 Corporate and municipal bonds are discussed in detail in the following sections.
Corporate Bonds Corporate bonds are issued by large investor-owned businesses (corporations),
while municipal bonds are issued by governments and governmental agencies other than federal. In this section, the primary focus is on corporate bonds, but much of the discussion also is relevant to municipal bonds. The unique features of municipal bonds will be discussed in the next major section.
Although bonds generally have maturities in the range of 20 to 30 years, shorter maturities, as well as longer maturities, are occasionally used. In 1995, HCA (Hospital Corporation of America) issued $200 million of 100-year bonds, following the issuance of 100-year bonds by Disney and Coca-Cola in 1993. Ultra-long-term bonds had not been issued by any firm since the 1920s and have not been issued since. Unlike term loans, bonds usually pay only interest over the life of the bond, and the entire amount of principal is returned to bondholders at maturity.
Most bonds have a fixed interest rate, which locks in the current rate for the entire maturity of the bond and hence minimizes interest payment uncertainty. However, some bonds have a floating, or variable, rate that is tied to some interest rate index, so the interest payment fluctuates as the general level of interest rates rises and falls. Floating-rate bonds are more prevalent when rates are high, when the yield curve (which is discussed later ln the chapter) has a steep upward slope, or when both of these conditions
220 Understanding Healthcare Finance Management
are present. Floating-rate bonds are riskier to the issuer because interest rates can rise in the future, but virtually all such debt has call provisions (discussed later) that permit issuers to replace the floating-rate debt with fixed-rate debt if conditions so dictate. Conversely, floating-rate bonds are less risky to buy ers, so they carry an initial interest rate that is lower than that set on simi|ar fixed-rate issues.
Some bonds do not pay periodic interest but are sold at a substantia] discount from face (principal) value. Such bonds, called zero-coupon bonds provide the investor (lender) with capital appreciation rather than interest income. For example, a zero-coupon bond with a $1,000 face value and ten year maturity might sell for $385.54 when issued. An investor who buys the bond would realize a 10 percent annual rate of return if he held the bond to maturity, even though he would receive no interest payments along the way. (Note however, for tax purposes, the return to zero-coupon bond investors is treated as interest income rather than capital gains income.) Other bonds, instead of paying interest in cash, pay coupons that grant the lender addi- tional bonds (or a proportion of an additional bond). These bonds are called payment-in-kind (PIK) bonds. PIK bonds usually are issued by companies in poor financial condition and hence tend to be highly risky.
In rare cases, bonds have step-up provisions, meaning the interest rate paid on the bond is increased if the bond’s rating is downgraded. (A bond's rating is downgraded when the issuing company’s financial condition has deteriorated. Bond ratings are discussed in a later section.) A step-up provi- sion is very risky for the issuing company because they must pay a higher interest rate at the worst possible time—when their financial condition weak- ens. Conversely, such a provision reduces the risk to buyers (lenders).
The bottom line here is that bonds in general, and corporate bonds in particular, come in many different flavors. In a healthcare financial manage- ment text, we can only scratch the surface.
Municipal Bonds Whereas corporate bonds are issued by investor-owned businesses, municipal bonds, or “munis,” are issued by states and their political subdivisions, includ- ing counties and cities. Although most municipal bonds are backed by the taxing power of the issuing entity, revenue bonds are backed by the revenues derived from facilities—such as toll roads and airports—deemed to be benefi- cial to the community. Of importance to healthcare managers, not-for-profit healthcare providers are entided to issue such securities through government- sponsored healthcare financing authorities.
Because the interest on municipal debt is exempt from federal income taxes, as well as state income taxes in the state of issue, investors are willing to accept lower interest rates on such debt than on comparable-risk taxable
Chapter 6: Debt Financing 221
debt. For example, assume that the interest rate on a highly rated, long-term corporate bond was 6.2 percent, while the rate on a similar-risk healthcare muni was 5.0 percent. To an individual investor in the 40 percent federal- plus-state tax bracket, the muni bond’s equivalent taxable yield is 5.0%/(l - 0.40) = 5.0%/0.6 = 8.3%, or about 2 percentage points above the corporate bond. It is easy to see why investors in high tax brackets are so enthusiastic about municipal bonds. On the surface, it might appear that the ability to obtain debt financing at relatively low rates (5.0 percent versus 6.2 percent in our example) creates a cost-of-financing advantage for not-for-profit pro- viders. However, as we discuss in Chapter 10, this advantage is offset by the ability of taxable providers to deduct interest expense from taxable income.
The issuance of municipal bonds by healthcare providers is big busi- ness. In 2013, not-for-profit healthcare companies issued more than $20 bil- lion of municipal bonds, and the total amount of debt outstanding is almost $400 billion. Most municipal bonds arc sold in rmWform—that is, a portion of the issue matures (comes due) periodically, anywhere from 6 months to 30 years or more after issue. Whereas most federal government (Treasury) and corporate bonds are held by institutions, about half of all healthcare munici- pal bonds outstanding are held by individual investors.
In contrast to corporate bonds, municipal bonds are not required to be registered with the Securities and Exchange Commission (SEC). How- ever, prior to bringing municipal debt to market, issuers are required to pre- pare an official statement that contains relevant financial information about the issuer and the nature of the bond issue. In addition, issuers are required to (1) provide annual financial statements that update the information con- tained in the official statement and (2) release information on material events that can affect bond values as such events occur. This information is not sent directly to investors but rather goes to data banks that can be easily accessed by investment bankers, mutual fund managers, and institutional investors. In theory, by making the information available to investment bankers who handle public trades, any individual who wants to buy or sell a municipal bond will also have access to information that affects the bond’s value.
For an illustration of the use of municipal bonds by a healthcare pro- vider, consider the $56 million in municipal bonds issued in March 2014 by the Bay Area Health Facilities Authority. The Authority is a public body created under Florida’s Health Facilities Authorities Law for the sole purpose of issuing health facilities municipal revenue bonds for qualifying healthcare providers. For this particular bond issue, the provider is Palm Coast Medical Center, a not-for-profit hospital, and the primary purpose of the issue is to raise funds to build and equip a new children’s wing. The bonds are secured solely by the revenues of Palm Coast, so the municipal conduit agency— the Bay Area Health Facilities Authority—has no responsibility whatsoever
222 Understanding Healthcare Finance Management
EXHIBIT 6.1
Palm Coast Medical
Center Municipal Bond Issue:
Maturities, Amounts, and Interest Rates
Approximate Maturity0 Amount Interest Rate 2015 $ 705,000 2.8% 2016 740,000 3-2 2017 785,000 3-5 2018 825,000 3-6 2019 880,000 3-8 2020 925,000 3-9 2021 985,000 4.0 2022 1,050,000 4.1 2023 1,115,000 4-2 2024 1,190,000 4-3 2029 5,590,000 4.6 2034 9,435,000 4-9 2044 31,775,000
$56,000,000 5-0
a All serial issues mature on March 1 of the listed year.
regarding the interest or principal payments on the issue. Exhibit 6.1 shows the maturities and interest rates associated with the issue.
Note the following points:
• The issue is a serial issue—that is, the $56 million in bonds is composed of 13 series, or individual issues, with maturities ranging from 1 year to 30 years.
• Because the yield curve on municipal bonds was normal, or upward sloping, at time of issue, the interest rates increase across the series as the maturities increase. (The yield curve is discussed in the chapter supplement.)
• The bonds that mature in 2024, 2034, and 2044 have sinking fund provisions (which we discuss in a later section) that require the hospital to place a specified dollar amount with a trustee each year to ensure that funds are available to retire the issues as they become due.
• Although it is not shown in the exhibit, the hospital’s annual debt service requirements—the amount of principal and interest that it has to pay on the issue—are relatively constant over time. The purpose of structuring the series so that the debt service requirements are spread evenly over time is to match the maturity of the issue to the maturity of the asset being financed. Think about it this way: The children’s wing has an operational life of about 30 years, and during this time, it will be generating revenues more or less evenly and its value will decline more or less evenly. Thus, the hospital has structured the debt
Chapter 6: Debt Financing
series so that the debt service requirements can be met by the revenues expected to be generated by the children’s wing. At the end of 30 years, the debt will be paid off, and Palm Coast Medical Center will probably be planning for a major renovation or a replacement facility that will be funded, at least in part, by a new debt issue.
1. Describe the primary features of long-term debt securities. 2. What is the primary motivation for investors to purchase municipal
bonds? 3. Describe the major differences between corporate and municipal
bonds. 4. What is a serial issue, and why is it used?
SELF-TEST QUESTIONS
Short-Term Debt
Thus far, we have focused on long-term debt. However, as pointed out in the introduction to this chapter, healthcare providers use about 5 percent short-term debt in their total financing mix. This section provides some of the details associated with short-term debt financing, generally loans with a maturity of one year or less.
Short-term credit has two primary advantages over long-term debt. First, a short-term loan can be obtained much faster than can long-term credit. Lenders will insist on a more thorough credit assessment (financial examination) before extending long-term credit, and the loan agreement will have to be spelled out in considerable detail because much more can happen during the life of a 30-year bond than during the life of a six-month loan. Thus, businesses that require funds in a hurry look to the short-term markets.
Second, if the need for funds is temporary (seasonal or cyclical), a firm may not want to commit to long-term debt for the following four reasons:
1. Issuance costs are generally higher on long-term debt than on short- term debt. (Issuance costs—sometimes called flotation costs—are the administrative costs associated with obtaining financing. For debt financing, these costs include legal and accounting fees, printing costs, loan application fees, and credit assessment fees, among others.)
2. Although long-term debt can be repaid early, provided the loan agreement includes a prepayment provision, prepayment penalties can be expensive. Accordingly, if a firm thinks its need for funds may diminish in the near future, it should choose short-term debt for the flexibility it provides.
Understanding Healthcare Finance Management
224
3. Long-term loan agreements typically contain restrictive covenants that constrain the firm’s future actions. Short-term credit agreements are generally much less onerous in this regard.
4. The interest rate on short-term debt generally is lower than the rate on long-term debt. Thus, when coupled with lower issuance costs, short- term debt can have a significant total cost advantage over long-term debt.
Despite these advantages, short-term credit has one serious disadvan- tage: It subjects the firm to more risk than does long-term financing. First, if a firm borrows on a long-term basis, its interest costs will be relatively stable over time, but if it uses short-term credit, its interest expense can fluctuate widely. For example, the short-term rate (the prime rate) that banks charge large corporations more than tripled over a two-year period in the early 1980s, rising from 6.25 percent to 21 percent. Many businesses that had borrowed heavily on a short-term basis could not meet their rising interest costs; as a result, business bankruptcies hit record levels during that period. Exposure to increasing interest rates is called rollover risk.
Second, the principal amount on short-term debt comes due on a regular basis. If the financial condition of a business deteriorates, the business may be unable to repay this debt when it matures. Furthermore, the business may be in such a weak financial position that the lender will not extend the loan. For the borrower, such a scenario can cause severe problems, which (like unexpectedly high interest rates) can force the business into bankruptcy. The risk that a business will not be able to roll over, or renew, its short-term debt is called renewal risk.
Because of the added risk associated with short-term debt, most busi- nesses use such debt solely to meet short-term financing needs (such as to pay for a temporary buildup of medical supplies to meet seasonal demand). To meet more permanent debt financing needs (such as to pay for construc- tion of a new outpatient surgery center), businesses typically use long-term debt.
SELF-TEST QUESTIONS 1. What are the advantages and disadvantages of short-term debt
versus long-term debt? 2. Explain the difference between rollover risk and renewal risk.
Credit Ratings
Since the early 1900s, corporate and municipal bonds, as well as other types of debt, have been assigned credit ratings that reflect their probability of going
into default. In addition to individual debt issues, a business’s overall financial
Chapter 6: Debt Financing 225
capacity (or creditworthiness} can be rated. The three major credit rating agencies are Fitch Ratings (Fitch), Moody’s Investors Service (Moody’s), and Standard & Poor’s Corporation (S&P). On large issues, more than one agency rates the debt, while on smaller deals, one agency is sufficient.
In general, the ratings of these agencies are consistent with one another, although occasionally the agencies will give different ratings to the same firm or issue. Although there are minor variations in the rating grades among the three agencies, the S&P issue ratings, given in Exhibit 6.2, are representative. Furthermore, in the discussion to follow, reference to the S&P code implies similar ratings by the other agencies.
Note that debt with a BBB rating or higher is called investment grade, which is the lowest-rated debt that many institutional investors are permitted by law to hold. Double B and lower debt, called junk debt, is more specula- tive in nature because it has a much higher probability of going into default than does higher-rated debt.
Rating Description
AAA AAA is the highest rating assigned. The issuer’s capacity to meet the debt obligation is extremely strong.
AA This rating differs from AAA by only a small degree. The issuer’s capacity to meet the debt obligation is very strong.
A The obligation is somewhat more susceptible to adverse changes in circumstances and economic conditions than those with higher ratings. However, the issuer’s capacity to meet its financial commitment is still strong.
BBB The obligation has adequate protection. However, adverse economic conditions or changing circumstances are more likely to weaken the issuer’s capacity to meet its obligation. Debt rated lower than BBB is regarded as having significant speculative characteristics.
BB This rating is less vulnerable to nonpayment than other speculative issues. However, ongoing uncertainties or exposure to adverse conditions can lead to inadequate capacity to meet the financial commitment.
B The issuer currently has the capacity to meet the obligation, but adverse conditions will likely lead to inadequate capacity.
CCC This issue is currently vulnerable to nonpayment. The issuer’s ability to meet its obligation depends on favorable conditions. Unfavorable conditions are likely to lead to nonpayment.
CC This obligation is highly vulnerable to nonpayment. This rating is typically used on an obligation when a bankruptcy
petition has been filed but payments are still being made. D The obligation is in default.
EXHIBIT 6.2 S&P Issue Credit Ratings
Note: The credit rating agencies use “modifiers” for ratings below AAA. For example, S&P uses a Plus and minus system. Thus, within the A rating category, A+ designates the strongest, and the weakest.
Rating Criteria Although the rating assignments are subjective, they are based on both quali tative characteristics and quantitative factors. Clearly, quantitative analyses that assess financial condition are an important consideration in the rating process. In addition, the quality and effectiveness of management, organi zational structure, competitiveness of the service area, risks associated with medical staff and third-party-payer relationships, and local demographic and economic considerations all influence credit ratings.
Analysts at the rating agencies have consistently stated that no precise formula is used to set a credit rating; many factors are taken into account but not in a mathematically precise manner. Statistical studies have supported this contention. Researchers who have tried to predict debt ratings on the basis of quantitative data alone have had only limited success, which indicates that the agencies do use a good deal of subjective judgment in the rating process.
Importance of Credit Ratings Credit ratings are important to both businesses and investors. First, a credit rating is an indicator of the default risk of the debt, or of the business as a whole, so the rating has a direct, measurable influence on the interest rate required by investors and hence on the firm’s cost of debt capital. Second, most corporate bonds are purchased by institutional investors rather than by individuals. Many of these institutions are restricted by law or charter to investment-grade securities. Also, most individual investors who buy munici- pal bonds are unwilling to purchase high-risk bonds. Thus, if an issue has a rating below BBB, the issuer will have a harder time selling the debt because the number of potential purchasers will be reduced. Because of its higher risk and more restricted market, low-grade debt typically carries much higher interest rates than does high-grade debt. (We will illustrate the impact of credit rating on interest rates in the next major section.)
Rating Changes A change of credit rating will have a significant effect on the business’s abil- ity to obtain debt capital and on the cost of that capital. Rating agencies continually review current information about issuers and debt that has been rated. If a major change occurs in an issuer’s near-term or long-term credit outlook, the issuer’s ratings are placed under review for possible change. For example, S&P will announce that a firm, or issue, has been placed on Credit- Watch-with either a positive or a negative implication. Such an announcement warns investors that a firm, or one or more of its issues, is under review and a rating change could occur. If circumstances dictate such a change, the rating agency will later announce an upgrade or a downgrade.
In addition to the routine review of credit ratings, an announcement that a firm plans to sell a new debt issue, or to merge with another firm and
Chapter 6: Debt Financing 227
pay for the acquisition by issuing new debt, will trigger agency reviews and possibly lead to a rating change. Thus, if a business’s situation has deterio- rated somewhat, but its debt has not been reviewed and downgraded, it may choose to use a term loan or short-term debt to raise capital rather than to finance through a public bond issue that would require re-grading. This strategy is used to postpone a rating agency review until the situation has had time to improve.
1. What are the major rating agencies? 2. What are some criteria that the rating agencies use when assigning
ratings? 3. What impact do debt ratings have on the cost of debt to the
issuing firm?
SELF-TEST QUESTIONS
Interest Rate Components
Although interest rates are set by the interaction of supply and demand for debt capital, the suppliers of debt capital (creditors) base their decisions for each debt security on a minimum required rate of return (interest rate), which depends on several components. By understanding these components, one can gain insights on why interest rates change over time, differ among borrowers, and even differ on separate issues by the same borrower.
Real Risk-Free Rate The base on which all interest rates are built is the real risk-free rate (RRF). The RRF is the rate that investors would demand on a debt security that is totally riskless when there is no inflation. Although difficult to measure, the RRF is thought to fall somewhere in the range of 2 percent to 4 percent under normal con- ditions. However, actions by the Federal Reserve can cause the RRF to fall outside of this range for some periods, especially when applied to short-term interest rates.
Criticisms of Credit Rating Agencies Large rating agencies (RAs), such as Standard & Poor’s, have come under increasing criticism in recent years for a multitude of reasons. Here are just a few.
First, the RAs are too cozy with the compa- nies they rate. The close relationships with man- agement, which include frequent meetings along with advice on actions companies should take to maintain current ratings, foster a familial atmo- sphere that interferes with independent, unbi- ased rating judgments. Furthermore, because the RAs are paid by the companies they rate, rather than the investors they are meant to protect, a clear conflict of interest exists.
Second, because the rating business is repu- tation based (why pay attention to a rating that is not recognized by others?), barriers to market entry are high, and the RAs are oligopolists. (An oligopoly is a market that is dominated by just a few sellers.) This means that the RAs are some- what immune from forces that apply to competi- tive markets and, to an extent, can set their own rules.
Finally, in many instances, the debt mar- kets (through lower bond prices) have indicated a company’s deteriorating credit quality many months before a rating downgrade occurred.
(continued)
228 Understanding Healthcare Finance Management
(continued from previous page) This fact has led many observers to suggest that, rather than rely on ratings, investors and regulators should use credit spreads to make judgments about credit risk. (Credit spreads reflect the difference in yields between interest rates on “safe” debt, such as Treasury securities, and rates on risky debt, such as B-rated bonds.)
Note that in the real world, inflation js rarely zero, and most debt securities have some risk. Thus, the actual interest rate on a given debt security will typically be higher than the RRF.
Inflation Premium Inflation has a major impact on interest rates because it erodes the purchasing
power of the dollar and lowers the value of investment returns. Creditors which are the suppliers of debt capital, are well aware of the impact of infla- tion. Thus, they build an inflation premium (IP) into required interest rates that is equal to the expected inflation rate over the life of the security.
For example, suppose that the RRF is 2 percent and that inflation is expected to be 2 percent during the next year. Hence, the IP is equal to 2 percent. The rate of interest on a one-year riskless debt security would be 2% + 2% = 4%. The combination of the RRF and IP is called the risk-free rate (RP). Thus, the risk-free rate incorporates inflation expectations but does not incorporate risk factors. In this example, the RF is 4 percent.
The rate of inflation built into interest rates is the rate of inflation expected in the future, not the rate experienced in the past. Thus, the latest reported inflation data may show an annual inflation rate of 1 percent, but that rate is for a past period. If investors expect a 2 percent inflation rate in the future, 2 percent would be built into the current rate of interest. Also, the inflation rate built into the inflation premium is the average rate of infla- tion expected over the life of the security. Thus, the inflation rate built into a one-year debt security is the expected inflation rate for the next year, but the inflation rate built into a 30-year security is the average rate of inflation expected over the next 30 years.
Default Risk Premium The risk that a borrower will default (not make the payments promised)
has a significant impact on the interest rate set on a debt security. This risk, along with the possible consequences of default, is captured by a default risk premium (DRP). Treasury securities have no default risk; thus, they carry the lowest interest rates on taxable securities in the United States. For corporate and municipal bonds, the higher the bond’s rating, the lower its default risk. All else the same, the lower the default risk, the lower the DRP and hence the interest rate.
Exhibit 6.3 lists the interest rates on some representative long-term bonds with different ratings in March 2014. The difference between the interest rate on a T-bond and that on a corporate bond with similar maturity,
Chapter 6: Debt Financing 229
Interest Rate
Rating Taxable Tax-Exempt
USTreasury 3.6% — AAA 4.0 3.1% AA 4-3 3-4 A 4-6 4-7 BBB 6.7 5-2 BB 7-9 6.6 B 9-1 8.0 CCC 12.0 9.6
EXHIBIT 6.3 Representative Long-Term Interest Rates in March 2014
liquidity, and other features is the DRP. Therefore, if the bonds listed were otherwise similar, the DRP would be 4.0% - 3.6% = 0.4 of a percentage point (40 basis points) for AAA corporate bonds, 4.3% - 3.6% = 0.7 of a percentage point (70 basis points) for AA corporate bonds, 4.6% - 3.6% = 1.0 percent- age point (100 basis points) for A corporate bonds, and so on. Bonds rated below BB are called junk bonds, and such bonds tend to have large DRPs. For example, the DRP for CCC-rated corporate bonds is a whopping 8.4 percentage points. The DRPs for tax-exempt healthcare bonds are calculated by using the rate on AAA-rated bonds as the basis because there are no tax- exempt T-bonds. Thus, tax-exempt DRPs are not “pure” DRPs as in the case of corporate bonds, which can be compared to default-free Treasury securities.
In addition to the probability of default, the DRP incorporates a sec- ond risk factor called recovery risk. For example, consider an issuer that has both mortgage bonds and subordinated debentures outstanding, each car- rying the same default rating. Yet, if default occurred, the mortgage bond- holders would have a much better chance of recovering the Rill amount due to them than would the debenture holders (because the debenture holders have no collateral). Thus, the DRP would be higher on the debenture than on the mortgage bond, even though both bonds have the same credit rating.
Default risk premiums change over time as the degree of investors’ risk aversion changes. For example, if investors believe that businesses will face a tougher operating environment in the future than they did in the immedi- ate past, DRPs will increase. Conversely, if the fiiture is expected to bring an improved operating environment, DRPs will decrease.
Liquidity Premium A liquid asset is one that can be sold quickly at a predictable fair market price and thus can be converted to a known amount of cash on short notice. Active markets, which provide liquidity, exist for Treasury securities and for the
230 Understanding Healthcare Finance Management
stocks and bonds of large corporations. Securities issued by small businesses including healthcare providers that issue municipal bonds, are somewhat illiquid—they can be sold to raise cash, but they do not sell quickly or at a predictable price. Furthermore, illiquid assets require more effort to sell and hence have relatively high transactions costs. Transactions costs include com- missions, fees, spreads between asking and selling prices, and other expenses associated with selling an investment. Securities issued by very small busi- nesses, which typically have only a local presence, are very illiquid.
If a security is illiquid, debt suppliers will add a liquidity premium (LP) when they set their required interest rate. It is difficult to measure LPs with precision, but a differential of at least 2 percentage points is thought to exist between the least liquid and the most liquid financial assets of similar default risk and maturity.
Price Risk Premium As we demonstrate in a later section, the market value (price) of a long-term debt security declines sharply when interest rates rise. Because interest rates can and do rise, all long-term debt securities, including Treasury bonds, have an element of risk called price risk. For example, if an individual bought a 20-year Treasury bond for $1,000 in November 2012, w'hen the long- term interest rate on such securities was about 2.5 percent, and held it until November 2013, when T-bond rates were roughly 3.5 percent, the value of the bond would have declined to about $863. This decline would represent a loss of about 13.7 percent, which demonstrates that long-term bonds—even US Treasury bonds—are not riskless.
As a general rule, the price risk of the debt of any organization—from the US government to HCA to Palm Coast Medical Center—increases as the maturity of the debt lengthens. Therefore, a price risk premium (PRP), which increases as the term to maturity lengthens, must be included in the interest rate. The effect of PRPs is to raise interest rates on long-term debt relative to those on short-term debt. This premium, like the others, is extremely dif- ficult to measure, but it seems to vary over time; it rises when interest rates are more volatile and uncertain, and it falls when they are more stable. In recent years, the PRP on 30-year T-bonds has been in the range of one-half to 2 percentage points.
Call Risk Premium Bonds that are callable can be redeemed by the issuer prior to maturity, and hence buyers have uncertain holding periods. This uncertainty makes callable bonds riskier for investors than those that are noncallable. To compensate for bearing call risk, investors charge a call risk premium (CRP) on callable bonds. The amount of the premium depends on such factors as the interest
Chapter 6: Debt Financing 231I rate on the bond, current interest rate levels, and time to first call. Histori- cally, CRPs have been in the range of 30 to 50 basis points.
Combining the Components When all the interest rate components listed above are taken into account, the interest rate on any debt security is expressed as follows:
Interest rate = RRF + IP + DRP + LP + PRP + CRP.
For example, assume that RRF is 2 percent and inflation is expected to average 3 percent in the coming year. Because T-bills have no default, liquid- ity, or call risk and almost no price risk, the interest rate on a one-year T-bill would be 5 percent:
Interest rate = RRF + IP + DRP + LP + PRP + CRP L -Dill
= 2% + 3% + 0 + 0 + 0 + 0 = 5%.
As discussed previously, the combination of RRF and IP is the risk-free rate, so the RF is 5 percent. In general, the rate of interest on short-term Treasury securities (T-bills) is used as a proxy for the short-term RF. Consider the callable 30-year, A-rated bonds issued by HCA. Assume that these bonds have an inflation premium of 4 percent; default risk, liquidity, and price risk premiums of 1 percent each; and a CRP of 40 basis points. Under these assumptions, the HCA bonds would have an interest rate of 9.4 percent:
Interest rate = RRF + IP + DRP + LP + PRP + CRP 30-year bonds
= 2% + 4% + 1% + 1% + 1% + 0.4% = 9.4%.
When interest rates are viewed as the sum of a base rate plus premiums for inflation and risk, it is easy to visualize the underlying economic forces that cause interest rates to vary among different issues and over time.
1. Write out the equation for the required interest rate on a debt security.
2. What is the difference between the RRF and the RF? 3. Do the interest rates on Treasury securities include a DRP? An
LP? A PRP? Explain your answer. 4. Does the DRP incorporate only the probability of default? Explain
your answer. 5. What is price risk? What types of debt securities have the largest
price risk premium?
SELF-TEST QUESTIONS
X
232 Understanding Healthcare Finance Management
Term Structure of Interest Rates
Usually, short-term interest rates are lower than long-term interest rates. The relationship between long- and short-term rates—which is called the term structure of interest rates—is important to healthcare managers (who must decide whether to borrow by issuing long- or short-term debt) and to inves- tors (who must decide whether to buy long- or short-term debt). Thus, it is important to understand how interest rates on long- and short-term debt are related to one another and what causes their relative positions to shift.
To examine the current term structure, look up the interest rates on debt of various maturities by a single issuer (e.g., the US Treasury) in a source such as the Wall Street Journal or the Federal Reserve Bulletin. For example, the tabular section of Exhibit 6.4 lists interest rates for Treasury securities of differ- ent maturities on three dates. The set of data for a given date, when plotted on
EXHIBIT 6.4 US Treasury
Bond Interest Rates on Three
Dates
Interest Rate
Years to Maturity
Interest Rate
Term to Maturity March 1980 March 1995 March 2014 6 months 15.0% 6.2% 0.1% I year 14.0 6.5 0.2 5 years 13-5 7.0 1.8 io years 12.8 7-2 3-0 20 years 12.5 7-3 3-9
Chapter 6: Debt Financing 233
a graph, is called a yield curve. As shown in the exhibit, the yield curve changes both position and shape over time. (Current interest rates are readily available online; for example, see www.marketwatch.com/tools/pftools/.)
Exhibit 6.4 shows yield curves for US Treasury securities, but the curves could have been constructed for similarly rated corporate or municipal (tax-exempt) bonds. In each case, the yield curve would be approximately the same shape but would differ in vertical position. For example, had the yield curve been constructed for Brookdale Senior Living, a for-profit nurs- ing home operator with more than 600 locations, it would fall above the Treasury curve because interest rates on corporate debt include default risk premiums, while Treasury rates do not. Conversely, the curve for Palm Coast Medical Center, a not-for-profit hospital, typically would fall below the Trea- sury curve because the tax-exemption benefit, which lowers the interest rate on tax-exempt securities, generally outweighs the default risk premium. In every case, however, the riskier the issuer (i.e., the lower the bonds are rated), the higher the yield curve plots on the graph.
Because long-term rates have historically been higher than short-term rates, at most times the yield curve is upward sloping. An upward-sloping curve would be expected if the inflation premium is relatively constant across all maturities because the price risk premium applied to long-term issues will push long-term rates above short-term rates. Because an upward-sloping yield curve is most prevalent, this shape is also called a normal yield curve, as illustrated by the curves for March 1995 and March 2014. Conversely, a yield curve that slopes downward is called an inverted, or abnormal, yield curve. Thus, in Exhibit 6.4, the yield curve for March 1980 is inverted. Additionally, yield curves can be “kinked” or can take other shapes, such as flat, but the yield curve is normal (upward sloping) most of the time. Note that the short-term yields on the March 2014 curve are exceptionally low. This is due to the Federal Reserve’s policy at that time of keeping short-term rates low to stimulate economic growth.
Healthcare managers use yield curve information to make decisions regarding debt maturities. For example, assume that it is March 2014 and that the yield curve for that month in Exhibit 6.4 applies to Palm Coast Medical Center. Also assume that the hospital plans to issue $10 million of debt to finance a new outpatient clinic with a 20-year life. If it borrowed in 2014 on a short-term basis—say, for one year—Palm Coast’s interest cost for that year would be 0.2 percent, or $20,000. If it used long-term (20-year) financing, its cost would be 3.9 percent, or $390,000. Therefore, at first glance, it would seem that Palm Coast should use short-term debt.
However, if the hospital uses short-term debt, it will have to renew the Ioan every year at the then-current short-term rate. Although unlikely, inter- est rates could return to their March 1980 levels. If they do, at some time in the future the hospital could be paying 14 percent, or $1.4 million per year. Conversely, if Palm Coast used long-term financing in 2014, its interest costs
would remain constant at $390,000 per year, so an increase in interest rates in the economy would not hurt the hospital.
Does this example suggest that businesses should always avoid short- term debt? Not necessarily. If Palm Coast had borrowed on a long-term basis for 3.9 percent in March 2014, it would be at a major disadvantage if interest rates remained low. Its interest expense would be locked in at $390,000 per year, while any competitors that used short-term debt that cost 0.2 percent would be able to continually renew the debt at the lower rate, or even less. Conversely, inflation expectations could push interest rates up to record levels. If that situation occurred, all borrowers would wish that they had bor- rowed on a long-term basis in 2014.
Financing decisions would be easy if managers could forecast future interest rates with any confidence. Unfortunately, predicting future interest rates with consistent accuracy is somewhere between difficult and impossi- ble—people who make a living by selling interest rate forecasts say it is dif- ficult, but many others say it is impossible. Sound financial policy, therefore, calls for using a mix of long- and short-term debt, as well as equity, in such a manner that the business can survive in all but the most severe and hence unlikely interest rate environments. Furthermore, the optimal financing policy depends on the maturities of the firm’s assets: In general, to reduce risk, managers try to match the maturities of the financing with the maturities of the assets being financed. The issue of optimal debt maturities is addressed in more detail in Chapter 10.
SELF-TEST QUESTIONS 1. What is a yield curve, and what information is needed to create
this curve? 2. What is the difference between a normal yield curve and an
inverted one? 3. If short-term rates are lower than long-term rates, why may a
business still choose to finance with long-term debt? 4. Explain the following statement: “A firm’s financing policy
depends in large part on the nature of its assets.”
Advantages and Disadvantages of Debt Financing
From the viewpoint of the issuer, there are several advantages to using debt financing as opposed to equity financing (discussed in Chapter 7):
• The cost of debt is independent of a business’s earnings, so creditors do not participate if profits soar. All of the “excess” value created by good business decisions accrues to the owner(s) of for-profit
Chapter 6: Debt Financing 235
businesses. For not-for-profit businesses, the value created can be used to further the mission of the organization.
• Because of the tax deductibility of interest for investor-owned businesses and the ability of not-for-profit firms to issue tax-advantaged (municipal) debt, the risk-adjusted component cost of debt is lower than that of common stock.
• The owners of a for-profit business do not have to share control with creditors.
• The use of debt financing enables not-for-profit businesses to offer more services than they could using only equity financing.
The major disadvantages are as follows:
• Because debt service (interest plus principal repayment) costs are fixed, a decline in operating income can result in default and possibly bankruptcy.
• As we discuss in Chapter 10, the use of debt financing increases the riskiness of the business and hence increases both debt and equity costs.
• Debt has a fixed maturity date and hence has to be repaid when due. If the business’s financial capacity at the time of a large principal repayment is limited, financial problems can result.
• Debt contracts, especially those for long-term debt, often contain covenants that restrict managerial actions.
• The amount of debt that can be raised at “reasonable” interest rates is limited.
1. What are the primary advantages and disadvantages of debt financing compared to equity financing?
SELF-TEST QUESTION
Securities Valuation
Now that you understand the basic features of debt securities, the next step is to learn how investors value them. Your reaction at this point might be, “Why should I have to worry about securities valuation when what I really want to learn about is healthcare financial management?” Securities valuation concepts are important to healthcare managers for many reasons. Here are just a few:
The lifeblood of any business is capital. The most common reason for small business failures is insufficient capital. Therefore, it is vital
236 Understanding Healthcare Finance Management
that healthcare managers understand how investors make investment allocation decisions.
• For investor-owned businesses, stock price maximization is an important, if not primary, goal, so healthcare managers of for-profit businesses must know how investors value the firm’s securities to understand how managerial actions affect stock price.
• To make financially sound investment decisions regarding real assets (facilities and equipment), healthcare managers need to estimate the business’s cost of capital, and a knowledge of securities valuation is essential to this process.
• All healthcare managers must grapple with the decision of how much debt financing, as opposed to equity, the business should use. An understanding of securities valuation is critical to this decision.
• Real assets, such as hospital beds and diagnostic equipment, are valued in the same general way as securities. Thus, securities valuation provides healthcare managers with an excellent foundation for learning real asset valuation, which is the heart of capital investment decision making in businesses.
In essence, we use the basic concepts presented here, with modifica- tions, in chapters 7, 9, 10, 11, and 12.
SELF-TEST QUESTION 1. Why are securities valuation concepts important to healthcare
financial management?
The General Valuation Model
Because the financial values of investment opportunities (both real assets and securities) stem from streams of expected cash flows, most investments are valued by the same four-step process:
1. Estimate the expected cash flow stream. Estimating the cash flow stream involves estimating both the expected cash flows and the times that they are expected to occur. For some types of investments, such as bonds, the estimation process is easy—the interest and principal repayment stream is fixed by contract. For other types of investments, such as a new service line, the estimation process can be difficult.
2. Assess the riskiness of the cash flow stream. For some investments, such as Treasury securities, it is fairly easy to assess the riskiness of the estimated cash flow stream. For other investments, it may be very difficult.
Chapter 6: Debt Financing 237
3 Set the required rate of return. Once the riskiness is assessed, the opportunity cost principle is applied to set the required rate of return. By making one investment, the funds are no longer available to make alternative investments. Thus, the required rate of return on the cash flow stream is established on the basis of the risk assessment and the returns available on alternative investments of similar risk.
4 Discount the expected cash flows and sum the present values. Each cash flow is discounted at the asset’s required rate of return (opportunity cost rate), and the present values are summed to find the value of the asset.
The following time line formalizes the general valuation process:
? R(R)
Pv EfCF.) Pv E(CF2) 4
Pv E(CF3) 4 PVE(CFN_1)4
3 __1
E(CF3 )
N-i
E(CFNJ
N
C(CFN)
Pv E(CFN) 4
Value
Here, E(CFt) is the expected cash flow in each period r, R(R) is the periodic required rate of return (the opportunity cost rate) on the invest- ment; and N is the number of periods for which cash flows are expected. The periods can be months, quarters, semiannual periods, or years, depending on the frequency of the cash flows expected from the investment.
The general valuation model can be applied to both financial assets (securities), such as stocks and bonds, and real (physical) assets, such as build- ings, equipment, and even whole businesses. However, the model can be used only when the cash flows expected from the investment can be esti- mated with some confidence. Each asset type requires a somewhat different application of the general valuation model, but the basic approach remains the same. In this chapter, the general valuation model is applied to debt secu- rities. In later chapters, the model is applied to common stocks, real assets such as diagnostic equipment, and to entire businesses.
E What is the general valuation model? 2. Under what conditions can it be used?
SELF-TEST QUESTIONS
238 Understanding Healthcare Finance Management
Origins of the Term Coupon Payment
The term coupon payment dates back to the time when all bonds were bearer bonds and physical possession of the bond certificate provided proof of ownership. Coupons, one for each scheduled interest payment over the life of the bond, were printed on the certificate. Here is an example of a coupon from the 1922 Mecca Temple (New York) construction bonds:
To collect an interest payment, bondholders would remove, or “clip,” the appropriate coupon and send it to the issuer or take it to a bank, where it would be exchanged for the dollar pay- ment. Today, all bonds are registered bonds, and the issuer (through an agent) automatically sends interest payments to the registered owner.
Debt Valuation
Unless they have unusual features, debt securities are valued by applying the general valuation model without much modification. We will use a 15-year bond to illustrate debt valuation, but the techniques discussed here are appli- cable to most types of debt.
Definitions To begin our discussion, let’s review some basic bond terminology:
• Par value. The par, or face, value is the stated value of the bond. It is often set at $1,000 or $5,000. The par value generally represents the amount of money the business borrows (per bond) and promises to repay at some future date.
• Maturity date. Bonds generally have a specified maturity date on which the par value will be repaid. For example, Big Sky Healthcare, a for-profit hospital system, issued $50 million worth of $1,000 par value bonds on January 1, 2014. The bonds will mature on December 31, 2028, so they had a 15-year maturity at the time of issue. The effective maturity of a bond declines each year after it was issued. Thus, at the
beginning of 2015, Big Sky’s bonds will have a 14-year maturity, and so on. • Coupon rate. A bond requires the
issuer to pay a specific amount of interest each year or, more typically, each six months. The rate of interest is called the coupon interest rate
or just coupon rate. The rate may be variable, in which case it is tied to some index—for example, 2 percentage points above the prime rate. More commonly, the rate will be fixed over the life (maturity) of the bond. For example, Big Sky’s bonds have a 10 percent coupon rate, so each $1,000 par value bond pays 0.10 x $1,000 = $100 in interest each year. The dollar amount of annual interest, in this case $100, is called the coupon payment. • New issues versus outstanding bonds. A bond’s value is determined by its coupon payment—the higher
Chapter 6: Debt Financing 239
the coupon payment, other things held constant, the higher its value. At the time a bond is issued, its coupon rate is generally set at a level that will cause the bond to sell at its par value. In other words, the coupon rate is set to match investors’ required rate of return on the bond (called the going rate). A bond that has just been issued is called a new issue. After the bond has been on the market for about a month, it is classi- fied as an outstanding bond or a seasoned issue. New issues sell close to par, but because a bond’s coupon payment is generally fixed, changing economic conditions—and hence the overall level of interest rates—will cause a seasoned bond to sell for more or less than its par value.
• Debt service requirements. Firms that issue bonds are concerned with their total debt service requirements, which include interest expense and repayment of principal. For Big Sky, the debt service requirement is 0.10 x $50 million = $5 million per year until maturity. In 2028, the firm’s debt service requirement will be $5 million in interest plus $50 million in principal repayment, for a total of $55 million. In Big Sky’s case, only interest is paid until maturity, so the entire principal amount must be repaid at that time. As we discussed earlier, many municipal bonds are serial issues structured so that the debt service requirements are relatively constant over time. In this situation, the issuer pays back a portion of the principal each year.
The Basic Bond Valuation Model Bonds generally call for the payment of a specific amount of interest for a specific number of years and for the repayment of par on the bond’s maturity date. Thus, a bond represents an annuity plus a lump sum, and its value is found as the present value of this cash flow stream:
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0 1 2 3 ... N I _________I __________I__________I___________I
INT INT INT INT M
INT INT INT + M UC = [1 + R(R)]1 + [1 + R(R)]2 + "' +[1 + R(R)]N ’
Here,
INT = dollars of interest paid each year = Coupon rate x Par value.
M = par, or maturity, value.
R(R) = required rate of return on the bond, which, in general, depends on the returns available on alternative investments of similar risk. For bonds, these returns depend on the real risk-free rate, infla- tion expectations, and the riskiness of the security.
Understanding Healthcare Finance Management
240
N = number of years until maturity. N declines each year after the bond is issued.
Here are the cash flows from Big Sky’s bonds on a time line:
o l 2 ... 13 14 15 I__________I _________I_____________I-----------------1-----------------1
$100 $100 $100 $100 $ 100 1,000
If the bonds had just been issued, and the coupon rate was set at the going interest rate for bonds of this risk, then R(R) = 10 percent. Because the value of the bond is merely the present value of its cash flows, discounted to Time 0 at a 10 percent discount rate, the value of the bond at issue was $1,000:
Present value of a 15-year, $100 payment annuity at 10 percent
Present value of a $1,000 lump sum discounted 15 years
Value of bond
= $ 760.61
239.39
= $1,000.00
The value of the bond can be found using a spreadsheet as
A B C D
1 2 10.0% Rate Interest rate 3 4 $100 Value 1 Yearicoupon 5 $100 Value 1 Year 2 coupon 6 $100 Value 1 Year 3 coupon
7 $100 Value 1 Year 4 coupon 8 $100 Value 1 Year 5 coupon
9 $100 Value 1 Year 6 coupon 10 $100 Value 1 Year 7 coupon 11 $100 Value 1 Year 8 coupon
12 $100 Value 1 Year 9 coupon
13 $100 Value 1 Year 10 coupon 14 $100 Value 1 Year 11 coupon
15 $100 Value 1 Year 12 coupon 16 $100 Value 1 Year 13 coupon 17 $100 Value 1 Year 14 coupon
18 $1,100 Value 1 Year 15 coupon + Principal 19
20 $1,000.00 =NPV(A2,A4:AI8) (entered into cell A20)
Note that we used the NPV function to value the bond. Also note that cell A.18 contains 1,100 as the entry, which reflects the $100 interest payment in Year 15 plus the $1,000 return of principal.
If R(R) remained constant at 10 percent over time, what would be the value of the bond one year after it was issued? Now, the term to maturity is
Chapter 6: Debt Financing 241
only 14 years—t^iat *s’ N = 14. As shown in the following spreadsheet, the bond’s value remains at $1,000:
A S C D 1 2 1O.O% Rate Interest rate
3 4 $100 5 $100 Value 1 Year 1 coupon
6 $100 Value 1 Year 2 coupon 7 $100 Value 1 Year 3 coupon
8 $100 Value 1 Year 4 coupon
9 $100 Value 1 Year 5 coupon 10 $100 Value 1 Year 6 coupon
11 $100 Value 1 Year 7 coupon
12 $100 Value 1 Year 8 coupon 13 $100 Value 1 Year 9 coupon
14 $100 Value 1 Year 10 coupon 15 $100 Value 1 Yearn coupon 16 $100 Value 1 Year 12 coupon
17 $100 Value 1 Year 13 coupon 18 $1,100 Value 1 Year 14 coupon + Principal
19
20 $1,000.00 =NPV(A2,A5:AI8) (entered into cell A20)
Note that the spreadsheet has the same inputs as when the bond had 15 years to maturity; however, the range listed in the NPV function was changed from A4:A18 to A5:A18 to reflect only 14 years to maturity.
Suppose that interest rates in the economy fell after the Big Sky bonds were issued and, as a result, R(R) decreased from 10 percent to 5 percent. The coupon rate and par value are fixed by contract, so they remain unaf- fected by changes in interest rates, but now the discount rate is 5 percent rather than 10 percent. At the end of the first year, with 14 years remaining, the value of the bond would be $1,494.93:
A B C D
1
2 5.0% Rate Interest rate 3 4 $100
5 $100 Value 1 Year 1 coupon
6 $100 Value 1 Year 2 coupon
7 $100 Value 1 Year 3 coupon 8 $100 Value 1 Year 4 coupon
9 $100 Value 1 Year 5 coupon 10 $100 Value 1 Year 6 coupon
11 $100 Value 1 Year 7 coupon 12 $100 Value 1 Year 8 coupon
13 $100 Value 1 Year 9 coupon 14 $100 Value 1 Year 10 coupon
15 $100 Value 1 Year 11 coupon
16 $100 Value 1 Year 12 coupon 17 $100 Value 1 Year 13 coupon
18 $1,100 Value 1 Year 14 coupon + Principal 19
20 $1,494-93 =NPV(A2,A5:AI8) (entered into cell A20)
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242
Here, we changed only the required rate of return in cell A2. The arithmetic of the bond value increase should be clear: Lower discount rates lead to higher present values. But what is the logic behind it? The fact that R(R) has fallen to 5 percent means that if an individual had $1,000 to invest she could buy new bonds like Big Sky’s—on average, 10 to 20 businesses sell new bonds daily—except that these new bonds would pay only $50 in inter- est each year. Naturally, she would favor $100 over $50 and would be willing to pay more than $1,000 for Big Sky’s bonds. All bond buyers would recog- nize this rationale; as a result, the Big Sky bonds would be bid up in price to $1,494.93, at which point they would provide the same rate of return as that provided by new bonds of similar risk: 5 percent.
If interest rates stay constant at 5 percent over the next 14 years, what would happen to the value of a Big Sky bond? It would fall gradually from $1,494.93 at present to $1,000 at maturity, when the firm will redeem each bond for $1,000. This point can be illustrated by calculating the value of the bond one year later, when it has only 13 years remaining to maturity:
A B C 0 1 2 5.0% Rate Interest rate 3 4 $100 5 $100
6 $100 Value 1 Year 1 coupon
7 $100 Value 1 Year 2 coupon 8 $100 Value 1 Year 3 coupon
9 $100 Value 1 Year 4 coupon
10 $100 Value 1 Year 5 coupon ll $100 Value 1 Year 6 coupon
12 $100 Value 1 Year 7 coupon
13 $100 Value 1 Year 8 coupon 14 $100 Value 1 Year 9 coupon
15 $100 Value 1 Year 10 coupon 16 $100 Value 1 Yearn coupon 17 $100 Value 1 Year 12 coupon
18 $1,100 Value 1 Year 13 coupon + Principal
19
20 $1,469.68 =NPV(A2,A6:Ai8) (entered into cell A20)
This time, we changed the range to A6:A18 to reflect 13 years to maturity. The resulting value of the bond is $1,469.68.
If an individual purchased the bond at a price of $1,494.93 and then sold it one year later with interest rates still at 5 percent, she would realize a capital loss of $1,494.93 - $1,469.68 = $25.25. The rate of return on the bond over the year consists of an interest, or current, yield plus a capital gains yield:
Key Equation 6.i: Current Yield on a Bond Current yield = Annual coupon payment / Beginning price
= $100 / $1,494.93 = 0.0669 = 6.69%.
Key Equation 6.2: Capital Gains Yield on a Bond
Capital gains yield = Annual capital gain (or loss) / Beginning price
= -$25.25 / $1,494.93 = -0.0169 = -1.69%.
Key Equation 6.3: Rate of Return (Total
Yield) on a Bond Rate of return (Total yield) = Total dollar return / Beginning price
= ($100 - $25.25) / $1,494.93
= $74.75 / $1,494.93 = 0.0500 = 5.00%.
Or,
Total yield = Current yield + Capital gains yield
= 6.69% + (-1.69%) = 5.00%. Had interest rates risen from 10 percent to 15 percent during the first
year after issue rather than fallen, the value of Big Sky’s bonds would have declined to $713.78 at the end of the first year. If interest rates held constant at 15 percent, the bond would have a value of $720.84 at the end of the second year, so the total yield to investors during Year 2 would be
Current yield = $100 / $713.78
Capital gains yield = $7.06 / $713.78
Rate of return, or total yield = $107.06 / $713.78
= 0.1401
= 0.0099
= 0.1500
= 14.01%
0.99%
= 15.00%
Exhibit 6.5 graphs the values of the Big Sky bond over time, assuming that interest rates will remain constant at 10 percent, fall to 5 percent and remain at that level, and rise to 15 percent and remain constant at that level. The exhibit illustrates the following important points:
• Whenever the required rate of return on a bond equals its coupon rate, the bond will sell at its par value.
• When interest rates—and hence required rates of return—fall after a bond is issued, the bond’s value rises above its par value and the bond sells at a premium.
• When interest rates—and hence required rates of return—rise after a bond is issued, the bond’s value falls below its par value and the bond sells at a discount.
• Bond prices on outstanding issues and interest rates are inversely related. Increasing rates lead to falling prices, and decreasing rates lead to increasing prices.
244 Understanding Healthcare Finance Management
• The price of a bond will always approach its par value as its maturity date approaches, provided the issuer does not default on the bond
Note, however, that interest rates do not remain constant over time so in reality, a bond’s price fluctuates as interest rates in the economy fluctu’ ate and as the bond’s term to maturity decreases. Still, regardless of interest rate movements, a bond’s value will approach its par value as the maturity date gets closer and closer.
Zero-Coupon Bonds Zero-coupon bonds pay no interest at all during the life of the bond, so
an investor’s cash flows consist solely of the return of par value at maturity
EXHIBIT 6.5 Time Path of
the Value of a 15-Year, 10%
Coupon, $1,000 Par Value Bond
When Interest Rates Are 5%, 10%, and 15%
Bond Value
Years
Bond Value at
Year R(R) = 5% R(R) = 10% R(R) = 15% 0 — $1,000.00 — 1 $1,494-93 1,000.00 $ 713-78 2 1,469.68 1,000.00 720.84 3 1.443-16 1,000.00 728.97
13 1,092.97 1,000.00 918.71 14 1,047.62 1,000.00 956.52 15 1,000.00 1,000.00 1,000.00
r Chapter 6: Debt Financing 245Because there are no interest payments, when the bond is issued its value is much less than par value, so the bond originally sells at a discount. Thus, zero-coupon bonds also are called original issue discount bonds.
Zero-coupon bonds are valued in the same way as regular (coupon) bonds, only there are no coupon payments to contribute to the bond’s value. For example, assume that Big Sky’s 15-year bond issue discussed in the previ- ous section was a zero-coupon bond. Assuming a 10 percent required rate of return, the bond’s value would be $239.39:
A B C D
1 2 10.0% Rate Interest rate 3 4 $- Value 1 Year 1 coupon 5 $- Value 1 Year 2 coupon
6 $- Value 1 Year 3 coupon 7 $- Value 1 Year 4 coupon
8 $- Value 1 Year 5 coupon
9 $- Value 1 Year 6 coupon 10 $- Value 1 Year 7 coupon
11 $- Value 1 Year 8 coupon 12 $- Value 1 Year 9 coupon 13 $- Value 1 Year 10 coupon 14 $- Value 1 Year 11 coupon
15 $- Value 1 Year 12 coupon
16 $- Value 1 Year 13 coupon 17 $- Value 1 Year 14 coupon
18 $1,000 Value 1 Year 15 coupon + Principal
19 20 $239-39 =NPV(A2,A4:AI8) (entered into cell A20)
Note that we zeroed out all cash flows except the principal payment at maturity. (Because cells A4 through Al8 were formatted as accounting values, zeroes are displayed as dashes.)
Zero-coupon bonds have some advantages as well as disadvantages when compared to coupon bonds. The primary advantage to issuers is that no payments have to be made to bondholders until the maturity date. As we will explain in a later section, the primary advantage to buyers is that there are no coupon payments to reinvest.
Yield to Maturity Up to this point, a bond’s required rate of return and cash flows have been used to determine its value. However, investors’ required rates of return on securities generally are not listed in either the print or online media. But cur- rent prices can be easily found—at least on bonds that are actively traded—by looking in many newspapers, including the Wall Street Journal., or online. Suppose that the Big Sky bond had 14 years remaining to maturity and the bond was selling at a price of $1,494.93. What percentage (rate of) return,
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ziitfi Understanding Healthcare Finance Management
or yield to maturity (1/TM), would be earned if the bond was bought at this price and held to maturity assuming no default occurs? To find the answer 5 percent, use a spreadsheet as follows:
A B C D
1 2 ($1,494.93) Values Bond price
3 $100 Values Year 1 coupon 4 $100 Values Year 2 coupon
5 $100 Values Year 3 coupon 6 $100 Values Year 4 coupon 7 $100 Values Year 5 coupon
8 $100 Values Year 6 coupon
9 $100 Values Year 7 coupon 10 $100 Values Year 8 coupon
11 $100 Values Year 9 coupon 12 $100 Values Year 10 coupon
13 $100 Values Year 11 coupon 14 $100 Values Year 12 coupon
15 $100 Values Year 13 coupon 16 $1,100 Values Year 14 coupon + Principal 17
18 5.0% =IRR(A2:Ai6) (entered into cell A18)
Note that the IRR function is used to calculate YTM. The YTM can be thought of as the expected rate of return on the bond.3 It is similar to the total rate of return calculated in the previous section. For a bond that sells at par, the YTM consists entirely of an interest yield, but if the bond sells at a discount or premium, the YTM consists of the current yield plus a positive or negative capital gains yield.
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Yield to Call A callable bond is one that can be called (redeemed) by the issuer prior to maturity. Because the maturity of the bond is shortened if it is called, call- able bonds have both a YTM and a yield to call (YTC). The YTC is similar to the YTM, except that it carries an assumption that the bond will be called. Thus, the YTC is calculated like the YTM, except that N reflects the number of years until the bond will be called as opposed to years to maturity and M reflects the call price rather than the maturity value.
For example, suppose the Big Sky bond had ten years of call protec- tion when it was issued. There are now nine years to the date of first call, and the bond is selling at a price of $1,494.93. Furthermore, there is a $100 call premium that must be paid by the borrower if the issue is called at the earliest possible date. What YTC would be earned if the bond were bought at this price and held to first call, at which time it was redeemed for $1,000 + $100 = $1,100? The answer is 4.2 percent:
Chapter 6: Debt Financing 247
A 8 C D
1 2 ($1,494.93) Values Bond price
3 $100 Values Year 1 coupon 4 $100 Values Year 2 coupon 5 $100 Values Year 3 coupon
6 $100 Values Year 4 coupon 7 $100 Values Year 5 coupon
8 $100 Values Year 6 coupon
9 $100 Values Year 7 coupon 10 $100 Values Year 8 coupon
11 $1,200 Values Year 9 coupon + Principal + Call premium
12 13 4.20% =IRR(A2:Au) (entered into cell A13)
Note that cell All contains $1,200: the par value of the bond ($1,000) plus the $100 call premium plus the $100 coupon payment for Year 9.
A question now faces potential investors in this bond: Should they expect to earn its 5.0 percent YTM or its 4.2 percent YTC? Of course, the answer depends on whether the bond will be called. There is no way of knowing with certainty today when, or even if, the bond will be called. We do know that the bond is selling at a large premium now, and if interest rates do not change much over the next nine years, the bond will likely be selling for more than $1,100 when first callable. If that is the situation, it is likely that the bond will be called, and hence the YTC is probably a better estimate of the expected rate of return than is the YTM. On the other hand, if the bond is currently selling at a discount, and interest rates are expected to be relatively constant over the next nine years, it is likely that the bond will not be called and thus the YTM would be the appropriate measure of the return on the bond. Unfortunately, no one knows today what interest rates will be nine years in the future.
Bond Values with Semiannual Coupons Virtually all bonds issued in the United States pay interest semiannually, or every six months. To apply the preceding valuation concepts to semiannual bonds, we must modify the bond valuation procedures as follows:
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• The annual interest payment, INT, must be divided by two to determine the dollar amount paid each six months.
• The number of years to maturity, N, must be multiplied by two to determine the number of semiannual interest periods.
• The annual required rate of return, R(R), must be divided by two to determine the semiannual required rate of return.
248 Understanding Healthcare Finance Management
For an illustration of the use of the semiannual bond valuation model assume that the Big Sky bonds pay $50 every six months rather than $100 annually. Thus, each interest payment is only half as large, but there are twice as many of them. When the going rate of interest is 5 percent annually, which translates to 2.5 percent semiannually, the value of Big Sky’s bonds with I4 years (28 semiannual periods) left to maturity is $1,499.12:
A B C D
1 2 28 Nper Number of periods 3 $50.00 Pmt Payment (coupon amount) 4 $1,000.00 Fv Future value (principal) 5 2.5% Rate Interest rate
6 7 8 $1,499.12 = -PV(A5,A2,A3,A4) (entered into cell A8)
9 10
Note several points regarding this spreadsheet calculation. First, we could have used the NPV function as we did in the previous bond valuation examples. However, to do so we would require a range with 28 cell entries for coupon payments, so we elected to use the Pv function to avoid all these entries. Second, when we use the Pv function for bond valuation, function wizard entries include both Pmt and Fv because bonds have both coupon payments and a maturity (principal) payment. Finally, we placed a minus sign in front of the function name (Pv) so that the value would be displayed as a positive number.
Similarly, if the bond were selling for $1,400 with 14 years to maturity, its YTM would be 5.80 percent:
A 8 C D 1 2 28 Nper Number of periods
3 $(1,400.00) Pv Present value (bond price) 4 $50.00 Pmt Payment (coupon amount) 5 $1,000.00 Fv Future value (principal)
6
7 8 2.90% =RATE(A2,A4,A3,A5) (entered into cell A8)
9 10
Here, we used the RATE function to calculate the YTM. The value shown in cell A8, 2.90 percent, is the periodic (semiannual) YTM, so we must multiply it by two to get the annual YTM. The effective annual YTM on the bond is somewhat greater than the 5.80 percent that was calculated.4
However, it is convention in the bond markets to quote all rates on a stated (annual) basis, so the procedures outlined in this section are correct when
Chapter 6: Debt Financing 249
bonds—all of which have semiannual coupons—are being compared. How- ever when the returns on securities that have different periodic payments are being compared, all rates of return should be expressed as effective annual rates.
Interest Rate Risk Interest rates change over time, which causes two types of investment risk generally classified as interest rate risk. First, an increase in interest rates causes the values of outstanding bonds to decline. Because interest rates can rise, bondholders face the risk of losses on their holdings. This risk is called price risk. Second, many bondholders buy bonds to build funds for future use. These bondholders reinvest the interest and principal cash flows as they receive them. If interest rates fall, bondholders will earn a lower rate on the reinvested cash flows, which will have a negative impact on the future value of their holdings. This risk is called reinvestment rate risk.
Price Risk For an illustration of price risk, suppose you bought some of Big Sky’s 10 percent bonds when they were issued at a price of $1,000. As illustrated ear- lier, if interest rates rise, the value of the bonds will fall. An investor’s expo- sure to price risk depends on the maturity of the bonds. Exhibit 6.6, which shows the values of 1-year and 14-year bonds at several different market interest rates, illustrates price risk. Notice how much more sensitive the value of the 14-year bond is to changes in interest rates. For bonds with similar coupons, the longer the maturity of the bond, the greater its price change in response to a given change in interest rates. Thus, investors in bonds with longer maturities are exposed to more price risk.5
Reinvestment Rate Risk Although a one-year bond exposes the buyer to less price risk than a 14-year bond does, the 1-year bond carries more reinvestment rate risk. Here’s why: If the holding period is more than one year, investing in a 1 -year bond means that the principal and interest will have to be reinvested at the end of the first year. If interest rates fall, the return earned during the second year will be less than the return earned during the first year. Reinvestment rate risk is the second dimension of interest rate risk.
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Minimizing Interest Rate Risk Clearly, bond investors face both price risk and reinvestment rate risk as a result of interest rate fluctuations over time. Which risk is most meaningful to a particular investor depends on the circumstances, but in general, interest rate risk is reduced by matching the maturity of the bond with the anticipated
250 Understanding Healthcare Finance Management
EXHIBIT 6.6 Value of Long-
and Short-Term 10% Annual
Coupon Rate Bonds at Different
Market Interest Rates
Bond Value
Bond ValueCurrent Market Interest Rate,
R(R) 2.5% 5-o
7-5 10.0
12.5 15.0 17-5
i-YearBond 14-YearBond
$1,073.17 $1,876.82 1,047.62 1.494-93 1,023.26 1,212.23 1,000.00 1,000.00 977.78 838.45 956.52 71378 936.17 616.25
How Safe Are Treasury Bonds? In the popular press, Treasury bonds (T-bonds) are commonly referred to as being ultra-safe. The party line goes something like this: “The US Treasury issues various securities of differing maturities. Like any widely traded security, you can buy them when they are issued and hold them (continued)
investment horizon. For example, suppose Hilldale Community Hospital received a $5 million contribution and plans to use it in five years to build a new neonatal care center. By investing the contribution in 5-year bonds, the hospital would minimize its interest rate risk because it would be matching its investment horizon. Price risk would be minimized because the bond will
Chapter 6: Debt Financing 251
mature in five years; Hilldale will receive ar value regardless of the level of interest rates at that time. Reinvestment rate risk is also minimized because only the interest on the bond would have to be reinvested, which is a less risky situation than if both principal and interest had to be rein- \ csted. Note that if Hilldale invested in a zero-coupon bond, reinvestment rate risk would be eliminated. Price risk, however, can never be completely eliminated in the sense that a forced sale of a bond prior to maturity in a higher interest rate environ- ment would result in a loss of principal.
Interest rate risk is but one of many financial risks facing healthcare businesses. Fortunately, various techniques can be used to mitigate such risks. We discuss financial risk management in some detail in Chapter 18 (Financial Risk Manage- ment), which is available exclusively online at ache.org/books/UHFM7.
(continued from previous page)
to maturity or buy and sell them in the market at any time. Because Treasury securities are backed by the US government, they are the ultimate safe investment.”
But are T-bonds, which have the longest maturities of all Treasury securities, really the ultimate safe investment? It all depends on how you define the word safe. Sure, they are safe from default risk, but they carry a great deal of price risk. To illustrate, in the summer of 2014, the interest rate on 30-year T-bonds was roughly 4 percent. If you bought a 30-year bond then at its $1,000 par value and interest rates rose to 6 percent in 2015, your bond, with 29 years left to maturity, would be worth only $727. If interest rates continued to rise, to 8 percent in 2015, the bond, with 28 years left to maturity, would be worth only $556. (In 1981, the rate on 30-year T-bonds was more than 13 percent, so the num- bers in this illustration are within the realm of possibility.) Sure, T-bonds are safe from default risk, but they carry a high level of price risk.
1. How are bonds valued? 2. What is a zero-coupon bond? 3. What is meant by a bond’s YTM? By its YTC? 4. Differentiate price risk from reinvestment rate risk.
SELF-TEST QUESTIONS
Chapter Key Concepts This chapter provides an overview of debt financing, including discussion on the determination of interest rates and the characteristics of the major types of debt securities. Here are its key concepts:
• Any business must have assets to operate, and to acquire assets, the business must raise capital. Capital comes in two basic forms: (1) dt^rand (2) equity {or fund') capital.
• Capital is allocated through the price system; a price is charged to “rent” money. Lenders charge interest on funds they lend, while
(continued)
252 Understanding Healthcare Finance Management
(continued from previous pagej
equity investors receive dividends and capital gains in return for letting the firm use their money.
• Term loans and bonds are long-term debt contracts under which a borrower agrees to make a series of interest and principal payments on specific dates to the lender. A term loan is generally sold to one or a few, lenders, while a bond is typically offered to the public and sold to many different investors.
• Many different types of bonds exist, including treasury, corporate, and municipal bonds. Prevailing interest rates, the bond’s riskiness, and tax consequences determine the return required on each type of bond.
• Revenue bonds are municipal bonds that pledge the revenues derived from projects, such as roads or bridges, airports, water and sewage systems, and not-for-profit healthcare facilities, as security for the bonds.
• Bonds are assigned ratings that reflect their probability of going into default. The higher a bond’s rating, and the greater the probability of recovering bondholder capital should default occur, the lower its interest rate.
• The interest rate on a debt security is composed of the real risk- free rate (RRF) plus premiums that reflect inflation (IP), default risk (DRP), liquidity (LP), price risk (PRP), and call risk (CRP): Interest rate = RRF + IP + DRP + LP + PRP + CRP.
• The relationship between the yields on securities and the securities’ maturities is known as the term structure of interest rates. The yield curve is a graph of this relationship.
• Debt financing has several advantages and disadvantages when compared to equity financing. The primary advantages are fixed payments, lower costs, and no control rights, whereas the primary disadvantage is the additional risk that debt financing brings to the business.
• Bonds call for the payment of a specific amount of interest for a specific number of years, and for the repayment of par on the bond’s maturity date. Like the value of most assets, a bond’s value is simply the present value of the expected cash flow stream.
• The annual rate of return on a bond consists of an interest, or current, yield plus a capital gains yield. If we assume that interest rates are constant, a bond selling at a discount yields positive capital gains, whereas a bond selling at a premium yields negative capital gains.
Chapter 6: Debt Financing 2537 • A bond’s yield to maturity (YTM) is the rate of return earned on a
bond if it is held to maturity and no default occurs. The YTM for a bond that sells at par consists entirely of an interest yield, but if the bond sells at a discount or premium, the YTM consists of the current yield plus a positive or negative capital gains yield.
• Bondholders face price risk because bond values change when interest rates change. In general, the longer the maturity of the bonds, the greater the price risk.
• Bondholders face reinvestment rate risk when the investment horizon exceeds the maturity of the bond issue.
Debt is a major source of capital for health services organizations, so healthcare managers must be familiar with debt concepts. In Chapter 7, we discuss equity financing, the second major type of capital.
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
• A chapter model that shows how to perform many of the calculations described in the chapter
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and tests your
ability to perform the calculations in preparation for a case
These resources can be accessed on the book’s companion website at ache.org/books/UHFM7.
Selected Cases
There are no cases that focus on the institutional details of debt financing. However, the following case in Cases in Healthcare Finance, 5th edition, can help you understand bond valuation:
• Case 14: Pacific Healthcare (A), which focuses on the valuation of corporate bonds as opposed to the managerial decisions inherent in floating a bond issue.
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Another case that focuses on related material is as follows:
• Case 16: Senior Care Enterprises, which focuses on the bond refunding decision. (Note that bond refunding is covered in the Chapter 6 Supplement.)
Selected Bibliography
Bernet, P. M., M. D. Rosko, and V. G. Valdmanis. 2008. “Hospital Efficiency and
Debt.” Journal of Health Care Finance 34 (4): 52-66.
Bernet, P. M., C. E. Carpenter, and Warren Saunders. 2011. “The Impact of Compe-
tition Among Health Care Financing Authorities on Market Yields and Issuer
Interest Expenses.” Journal of Health Care Finance 38 (1): 55-70.
Carpenter, C. E., and P. M. Bernet. 2013. “How the Choice of Issuing Authority
Affects Hospital Debt Financing Costs.” Healthcare Financial Management
67 (5): 80-84.
Conbeer, G. P. 2007. “Making the Right Long-Term Prescription for Medical
Equipment Financing.” Healthcare Financial Management 61 (6): 88-93.
Loubeau, P. R., and R. Jantzen. 2005. “U.S. Hospital Bond Ratings in the Managed
Care Era.” Journal of Health Care Finance 31 (3): 41-51.
McCue, M. J., and T. H. Kim. 2007. “Evaluating the Underlying Factors Behind
Variable Rate Debt.” Health Care Management Review 32 (4): 300-08.
Means, G. A., and M. L. Olarte. 2013. “Today’s Trends in Capital Financing.”
Healthcare Financial Management (May): 61-66.
Sandrick, K. M. 2008. “Navigating Today’s Opportunities for Capital.” Healthcare
Financial Management 62 (12): 78-83.
Wilson, B. 2009. “Financing to Meet Community Needs: A Guide for Small Hospi-
tals.” Healthcare Financial Management 63 (3): 74—79.
Zismer, D. K., J. Fox, and P. Torgerson. 2013. “Financing Strategic Healthcare
Facilities: The Growing Attraction of Alternative Capital.” Healthcare Finan-
cial Management 67 (5): 92-99.
Selected Websites
The following websites pertain to this chapter:
• For tabular term structure data and a graph of the yield curves for Treasury and municipal securities, see www.bloomberg.com/markets/ rates-bonds/.
Chapter 6: Debt Financing 255
• For current (updated daily) interest rate information, see the Federal Reserve site at www.federalreserve.gov/releases/H15/update. This site includes data on commercial paper, corporate bonds, and other rates in addition to the rates on Treasury securities.
• The S&P website provides a great deal of information on bond ratings. See www.standardandpoors.com.
Notes
1.The prime rate is the base rate that banks charge on loans to businesses. Theoretically, the prime rate is set separately by each bank, but in practice all banks follow the lead of the major New York City banks, so there is usually a single prime rate in the United States. The prime rate changes—sometimes rapidly—as economic conditions (primarily inflation expectations) change. In mid-2014, the prime rate was 3.25 percent.
2. Treasury bonds, or T-bonds, have original maturities at issue of more than ten years. The Treasury also issues notes, called T-notes, which have maturities of more than one year (up to ten years), and bills, called T-bills, which have maturities of one year or less. Note that the names of Treasury securities are fixed at issue even though their maturities shorten over time. Thus, a 30-year T-bond that was issued 25 years ago now has only five years remaining to maturity, but it is still classified as a bond, not a note.
3. If the probability of default on the bond is anything other than zero, the expected rate of return on the bond is less than the YTM. Also, the calculation of YTM assumes that the coupon payments are reinvested at the YTM rate. Thus, if interest rates over the life of the bond are above the YTM, the realized rate of return will be higher than the YTM. Similarly, if interest rates over time are less than the YTM, the realized return will be less than the YTM.
4. The effective annual YTM is (1.029)2 - 1.0 = 1.0588 - 1.0 = 0.0588 = 5.88%, as compared to the stated rate of 5.80%.
5. In reality, price risk is more related to a debt security’s duration than to its maturity. Duration, which can be thought of as the average maturity of a debt issue—including both interest and principal payments—is discussed in online Chapter 18.
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Integrative Application
The Problem
QuickCare, a not-for-profit system that owns and operates 34 walk-in clinics in central Florida, is planning to build and operate ten more clinics over the next few years. They estimate that land, construction, and startup costs for the clinics will be $100 million, and they plan to raise the necessary funds by issuing tax- exempt (municipal) bonds. Furthermore, their investment bankers believe that two maturities are most attractive at this time: 5-year bonds that would require a fixed interest rate of 3.5 percent and 20-year bonds with a fixed rate of 5 per- cent. You have been asked by the CEO to make a recommendation as to which maturity to use. Also, he is interested in investing personally in the bonds and wants to know what would happen to the value of each bond if interest rates rise by 1 percentage point during the first year of issue and the bonds had remain- ing maturities of 4 years and 19 years. (Experts predict that it is more likely that interest rates will increase in the future rather than decrease.) Finally, he would like to know what total return he would earn during the first year if the interest rate increase took place. Perform the analysis on a per bond basis assuming a par value of $1,000. Also, for convenience, assume the bonds have annual coupons.
The Analysis
First, calculate the value of each bond after one year if interest rates increase to 4.5 percent on the 5-year bond and 6.0 percent on the 20-year bond.
5-Year Bond A B C D
1
2 4 Nper Number of payments 3 $35.00 Pmt Payment (coupon amount) 4 $1,000.00 Fv Future value (principal) 5 4-5% Rate Interest rate 6 7 8 $964.12 = -PV(A5,A2,A3,A4) (entered into cell A8) 9 10
Chapter 6: Debt Financing
2o-YearBond B C D
19 Nper Number of payments $50.00 Pmt Payment (coupon amount)
$1,000.00 Fv Future value (principal)00 6.0% Rate Interest rate —
01 fll $888.42 = -PV(A5,A2,A3,A4) (entered into cell A8)
These values ($964.12 for the 5-year bond and $888.42 for the 20-year bond) illustrate price risk—when interest rates rise in the economy, the values of existing bonds decline. Now, consider the total returns.
5-YearBond Current yield = Annual coupon payment / Beginning price
= $35 I $1,000.00 = 0.0350 = 3.50%.
Capital gains yield = Annual capital gain (or loss) I Beginning price
= -$35.88 I $1,000.00 = -0.0359 = -3.59%.
Rate of return (Total yield) = Total dollar return / Beginning price
= ($35.00 - $35.88) I $1,000.00
= -$0.88 / $1,000.00 = -0.0009 = -0.09%.
Or, Total yield = Current yield + Capital gains yield
= 3.50% + (-3.59%) = -0.09%
20-Year Bond Current yield = Annual coupon payment / Beginning price
= $50 I $1,000.00 = 0.0500 = 5.00%.
Capital gains yield = Annual capital gain (or loss) / Beginning price
= -$111.58 / $1,000.00 = -0.1116 = -11.16%.
Total yield = Current yield + Capital gains yield
= 5.00% + (-11.16%) = -6.16%
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The Decision
First, consider the maturity decision for QuickCare. The business would mini- mize its financing risk by using the longer-term (20-year) bond because it better matches the maturity (useful life) of the assets being financed. Also, with inter- est rates expected to increase, a longer-term issue would lock in the current low rates. Thus, the board agreed to use the 20-year bonds to finance the new clinics.
Now, what about the CEO’s personal investment decision? If interest rates increase, the 5-year bond would have a total loss of 0.09 percent during the first year, while the loss on the 20-year bond would be 6.16 percent. Further- more, if interest rates continued to increase, the 20-year bond would be sub- jected to larger future losses. The shorter-term (5-year) bond, on the other hand, would mature in five years, and the principal could be reinvested at a higher interest rate. Thus, the CEO probably would better off investing in short-term bonds. Of course, this advice assumes that the expert predictions are correct, but they are often wrong. ■
CHAPTER SUPPLEMENT
INTEREST RATE LEVELS, TYPES OF SHORT- TERM DEBT, DEBT CONTRACTS, BOND INSURANCE, DEBT REFUNDING, AND ECONOMIC FACTORS THAT INFLUENCE INTEREST RATE LEVELS
Supplement Learning Objectives After studying this chapter supplement, readers should be able to
• describe how interest rate levels are set in the economy; • discuss the various types of short-term debt, including secured
debt; • explain the key features of debt contracts; • describe how bond insurance works; • perform a bond refunding analysis; and • explain the underlying economic factors that influence interest rate
levels.
Interest Rate Levels
Like any free market, debt markets set prices on the basis of supply and demand. For an illustration of the process, consider Exhibit S6.1, which shows how supply and demand interact in two debt markets—A and B. The going interest rate, designated I, is initially 10 percent for the low-risk secu- rities in Market A. Borrowers whose credit is strong enough to qualify for this market can obtain funds at a cost of 10 percent. Riskier borrowers must obtain higher-cost funds in Market B. Investors who are more willing to take risks invest in Market B and expect to receive a 12 percent return, but they dso realize that they might receive much less if the borrower’s business fails and the borrower is unable to make the interest payments or repay the loan.
If the demand for funds in a market declines, as it typically does dur- lng a business recession, the demand curve will shift to the left, as shown in curve D2 in Market A. The market-clearing, or equilibrium, interest rate in
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EXHIBIT S6.1 Interest Rates as a Function of Supply and
Demand for Funds
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Market A: Low-Risk Securities Interest Rate, I
Market B: High-Risk Securities
this example declines to 8 percent. Similarly, you should be able to visualize what would happen if the Federal Reserve (or the Fed) tightened credit: The supply curve, SI, would shift to the left, which would raise interest rates and lower the level of borrowing in the economy. In 2014, the Fed was pursuing a loose credit policy to try to stimulate the economy, so the supply curve was shifted far to the right and interest rates were at historically low levels.
Debt markets—indeed all capital markets—are interdependent. For example, if Markets A and B were in equilibrium before the demand shift to
Chapter 6 Supplement: Interest Rate Levels . . . 261
p in Market A, investors were willing to accept the higher risk in Market B in exchange for a risk ■premium of 12% - 10% = 2 percentage points. After rhe shift to D2, the risk premium would initially increase to 12% - 8% = 4 percentage points. In all likelihood, this much larger premium would induce some of the lenders in Market A to move to Market B, which would cause the supply curve in Market A to shift to the left (or up) and the supply curve in Market B to shift to the right (or down). This transfer of capital between markets would raise the interest rate in Market A and lower it in Market B, bringing the risk premium back closer to its original level—2 percentage points.
There are many capital markets in the United States, including markets for short-term debt (money markets) and for long-term debt and equity (capi- tal markets). These markets are further broken down into markets for home loans; farm loans; business loans for both taxable and tax-exempt firms; fed- eral, state, and local government loans; and consumer loans. Within each category, there are regional markets as well as different types of submarkets. For example, within the business sector there arc dozens of types of debt and also several sharply differentiated markets for common stocks. There is a price for each type of capital, and these prices change over time as shifts occur in supply-and-demand conditions.
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1. How does risk affect interest rates? 2. What happens to the market-clearing, or equilibrium, interest rate
when loan demand changes?
SELF-TEST QUESTIONS
Types of Short-Term Debt
The three most common types of short-term business debt are commercial paper, bank loans, and nontraditional loans. In addition, some short-term debt is secured by the borrower’s assets.
Commercial Paper Commercial paper is a type of unsecured debt issued by large, strong firms and sold primarily to other businesses, to insurance companies, to pension hinds, to money market mutual funds, and to banks. Although the amount °f commercial paper outstanding is smaller than bank loans outstanding, this form of financing has grown rapidly in recent years.
Maturities of commercial paper generally vary from one to nine months, with an average of about five months. The rate on commercial Paper fluctuates on the basis of supply and demand; it is determined in the
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marketplace and rises/falls daily as conditions change. Typically, commerce paper rates fall below the prime rate and slightly above the rate on short term Treasury debt (the T-bill rate). Commercial paper rates are low becaUsc issuers usually obtain backup credit from banks to guarantee the commercial paper repayment.
The use of commercial paper is restricted to businesses that are exccp tionally good credit risks. Dealers prefer to handle the paper of firms whose net worth is $100 million or more and whose annual borrowing exceeds SlO million. One potential problem with commercial paper is that a debtor who is in temporary financial difficulty may receive little help because commer- cial paper dealings are generally less personal than bank relationships. Thus banks are generally more able and willing than commercial paper dealers to help a valued customer weather a temporary storm. On the other hand, bv using commercial paper, a business can tap a wide range of credit sources including financial institutions outside its area and industrial corporations across the country, which can reduce interest costs.
Bank Loans Commercial banks, whose short-term loans generally appear on firms’ bal- ance sheets as notes payable, are the primary source of short-term financing. Although banks issue longer-term loans, the bulk of their lending is short term; about two-thirds of all bank loans mature in a year or less. Bank loans to businesses are frequently written as 90-day notes, so the loan must be repaid or renewed at the end of 90 days. When a bank loan is approved, the bank credits the borrower’s checking account with the amount of the loan, while both cash and notes payable increase on the borrower’s balance sheet.
Banks sometimes require borrowers to maintain a checking account balance equal to 10 to 20 percent of the face amount of the loan. This requirement is called a compensating balance, and such balances raise the effective interest rate on the loan. For example, suppose that Pine Garden Nursing Home needs an $80,000 short-term bank loan to meet temporary cash needs. If the loan requires a 20 percent compensating balance, Pine Garden must borrow $100,000 to obtain a usable $80,000, assuming that the business does not have an “extra” $20,000 around to use as a compen- sating balance. If the stated interest rate is 8 percent, the effective cost rate is actually 10 percent: 0.08 x $100,000 = $8,000 in interest expense divided by $80,000 of usable funds.
A line of credit—sometimes called a revolving credit agreement or just revolver—is a formal agreement between the bank and a borrower that speci- fies die maximum credit the bank will extend over some specified period. For example, in December a bank loan officer might indicate to Pine Garden’s manager that the bank regards the nursing home as being good for up to
Chapter 6 Supplement: Interest Rate Levels . . . 263
§80,000 during the coming year. If on January 10, Pine Garden’s manager decides to borrow $15,000 from the line, this borrowing is called taking down $15,000 of the credit line. This takedown would be credited to the nursing home’s checking account at the bank, and before repayment of the $15,000, Pine Garden could borrow additional amounts up to a total of $80,000 outstanding at any one time. Lines of credit are generally extended for one year, and borrowers typically have to pay an upfront commitment fee of about 0.5 percent to 1 percent of the total amount of the line in addition to interest on the amount taken down. Many businesses have a continuing relationship with a bank, which allows them to automatically renew the credit line year after year. However, if the business’s financial condition deteriorates, the bank has the right to deny renewal.
Revolvers typically involve large sums over longer periods. Consider the following example. In 2014, Colorado Healthcare negotiated a revolving credit agreement for $100 million with a group of banks. The banks were formally committed for four years to lend the firm up to $100 million if the funds were needed. In turn, Colorado Healthcare paid an annual commit- ment fee of one-quarter of 1 percent on the unused credit to compensate the banks for making the commitment. Thus, if Colorado Healthcare did not take down any of the $100 million commitment during a year, it would still be required to pay a $250,000 annual fee in monthly installments of $20,833.33. If it borrowed $30 million on the first day of the agreement, the unused portion of the credit line would fall to $70 million and the annual fee would fall to $175,000, but Colorado Healthcare would have to pay interest at the agreed-upon rate on the $30 million it borrowed. As a general rule, the rate of interest on credit lines is pegged to the prime rate, so the cost of the loan varies over time as interest rates change. Colorado Healthcare’s rate was set at prime plus one-half of a percentage point.
Nonbank Lenders In general, banks require solid credit scores and spend weeks reviewing financial statements, tax returns, and business plans before granting short- term loans. Furthermore, businesses in marginal financial condition often are turned down. To fill the credit void, nontraditional {alternative) lenders are able to quickly provide short-term, relatively small loans to businesses that might be shunned by banks.
In general, such loans are for $50,000 or less and repayment is required in six months or sooner. However, the interest rate on alternative lender financing is quite high—often 30 percent or more. These high rates are possible because such loans either are not covered by state usury laws or are originated by companies located in states without such laws. Although not for all businesses, alternative lenders do provide a service to business
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borrowers that either do not qualify for bank loans or need “quick money ” As one businessman said, “The rates are higher than bank loans, but they’rc quicker and a lot less aggravating.”
Secured Short-Term Debt If a business has a choice, borrowing on an unsecured basis is usually better because the administrative costs associated with secured loans are often high However, weak businesses may find that they can borrow only if they put up some form of security to protect the lender, or that by using security they can borrow at a much lower rate.
Several kinds of collateral, or security, can be employed, including marketable securities, land or buildings, equipment, inventory, and accounts receivable. Marketable securities make excellent collateral, but businesses that need short-term credit generally do not hold large portfolios of marketable securities. Real property (i.e., land and buildings) and equipment are also good forms of collateral. However, such assets are generally used as security for long-term debt rather than for short-term credit. Therefore, most secured short-term business borrowing involves the use of accounts receivable or inventories as collateral.
Accounts receivable financing involves either a pledge or sale of receivables. Such financing is provided by commercial banks or by one of the large industrial finance firms, such as GE Capital. The pledging of accounts receivable is characterized by the fact that the lender not only has a claim against the dollar amount of the receivables but also has recourse against the pledging firm. In other words, if the individual or third-party payer that owes the receivable does not pay, the business that borrows against the receivable must take the loss. Therefore, the risk of default on the pledged accounts receivable remains with the borrowing firm. When receivables are pledged, the payer is not ordinarily notified, and payments are made on the receivables in the same way as when receivables are not used as loan security.
The second form of receivables financing is factoring, or selling accounts receivable. In this type of secured financing, the lender “purchases” the receivables account and generally has no recourse to the borrowing busi- ness. In a typical factoring transaction, the buyer of the receivables pays the seller 90 percent to 95 percent of the face value of the receivables. When receivables are factored, the individual or third-party payer that owes the receivable may be notified of the transfer and asked to make payment directly to the firm that bought the receivables. However, in most cases, the receiv- ables buyer pays the selling business a fee to act as the collections agent. Because the factoring firm assumes the risk of default on bad accounts, it must perform a credit check on the receivables prior to the purchase. Accord- ingly, factors—the firms that buy receivables—can provide not only money
Chapter 6 Supplement: Interest Rate Levels . . . 265
but also a credit department for the borrower. Incidentally, the same financial Institutions that make loans against pledged receivables also serve as factors. Thus, depending on the circumstances and the wishes of the borrower, these institutions will provide either form of receivables financing.
Because healthcare providers tend to carry relatively large amounts of receivables, such firms are prime candidates for receivables financing. For exaniple, in 2014 hospitals alone had accounts receivable that totaled nearly $15 billion. The selling of these receivables, especially by hospitals that are experiencing liquidity problems, is one way to reduce carrying costs and stimulate cash flow.
To better understand receivables financing for hospitals, consider the program instituted between Chase Manhattan Bank (now known as J.P. Morgan Chase) and Presbyterian Hospital, New York City’s largest hospital. This program provides $15 million in advance funding of receivables over a three-year period. Presbyterian sells its accounts receivable to Chase for cash. In turn, Chase obtains the cash it needs by selling commercial paper. The payers of the receivables technically make payments directly to Chase, although Chase pays Presbyterian a fee to service the receivables accounts. Chase charges an upfront fee for the program and an interest rate of 1 per- cent to 1.5 percent above the prime rate on the amount advanced.
Although receivables financing is a way to reduce current assets and hence financing costs, critics contend that such programs are too expensive. Because of the costs involved, most receivables financing programs are used by providers that have serious liquidity problems, although programs are being developed that can provide benefits even to well-run providers that are not facing a liquidity crunch. Although the illustrations here have focused on the use of receivables financing by hospitals, medical group practices and other healthcare providers also use such financing.
Receivables financing dominates healthcare providers’ use of secured financing, but other healthcare businesses—such as equipment manufacturers and pharmaceutical firms—are more likely to obtain credit secured by busi- ness inventories. If a firm is a relatively good credit risk, the mere existence of the inventory may be sufficient to obtain an unsecured loan. However, if the firm is a relatively poor risk, the lending institution may insist on secu- rity, which can take the form of a blanket lien against all inventory or trust or warehouse receipts against specific inventory items. The inventory blanket Hen gives the lending institution a lien against all the borrower’s inventories. However, the borrower is free to sell inventories, so the value of the collateral can be reduced to less than the value it had when the loan was granted.
Because of the inherent weakness of the blanket lien, another proce- dure for inventory financing was developed. The security instrument, also called a trust receipt, is an instrument that acknowledges that the goods are
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held in trust for the lender. When trust receipts are used, the borrowing fy-J signs and delivers a trust receipt upon receiving funds from the lender Th goods pledged as collateral can be stored in a public warehouse or held the premises of the borrower. The trust receipt acknowledges that the goods are held in trust for the lender and that any proceeds from the sale of trust goods must be transmitted to the lender at the end of each day.
SELF-TEST QUESTIONS
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1. What are the primary differences between commercial paper and short-term bank loans?
2. How might a hospital that expects to have a temporary cash shortage during the coming year make sure that needed funds will be available?
3. What types of assets might be pledged as security for short-term loans?
Debt Contracts
Debt contracts, which spell out the rights of the borrower and lender(s), have different names depending on the type of debt. The contract between the issuer and bondholders is called an indenture. Indentures tend to be long—some run several hundred pages. For other types of debt, a similar but much shorter document called a loan agreement or promissory note is used. Healthcare managers are most concerned about the overall cost of debt, including issuance costs, and any provisions that may restrict the business’s future actions. In this section, we discuss some debt contract features that can affect the business’s future flexibility or the interest rate on the issue.
Restrictive Covenants Many debt contracts include provisions, called restrictive covenants, designed to protect creditors from managerial actions that would be detrimental to creditors’ best interests. For example, the Palm Coast Medical Center bond issue described earlier in the chapter contains several restrictive covenants, including the covenant that the issuer must maintain a minimum current ratio of 2.0. The current ratio is defined as current assets divided by current liabilities, so a current ratio of 2.0 indicates that current assets are twice as large as current liabilities. Because the current ratio measures a business’s liquidity—the ability to meet cash obligations as they become due—setting a minimum current ratio requirement provides some assurance to bondhold- ers that the borrower will be able to pay the interest and principal payments coming due. If Palm Coast violates any of its restrictive covenants—say, by allowing its current ratio to drop below 2.0—it is said to be in technical
Chapter 6 Supplement: Interest Rate Levels . .
default- (“Regular” default occurs when an interest or principal payment is injssed—that is, not paid on time.)
Trustees \Vhen debt is supplied by a single creditor, such as a commercial bank, there i one-to-one relationship between the lender and borrower. However, lb bond issues can have thousands of lenders, so a single voice is needed to represent bondholders. This function is performed by a trustee—usually a financial institution—that represents the bondholders and ensures that the terms of the indenture are being carried out. The trustee is responsible for ensuring that the loan covenants are not being violated and for taking appro- priate action if a violation does occur. What constitutes appropriate action varies with the circumstances. A trustee has the power to foreclose on an issue in default, which makes the full amount of principal and unpaid interest due and payable immediately. However, insisting on immediate payment may result in bankruptcy of the borrower and possibly large losses on the bonds. In such a case, the trustee may decide that, rather than impose bankruptcy, the bondholders would be better served by giving the issuer an opportunity to work out its problems.
Call Provisions A call provision gives the issuer the right to call a bond for redemption prior to maturity—that is, the issuer can pay off the bondholders in entirety and redeem, or retire, the issue. If it is used, the call provision generally states that the firm must pay an amount greater than the initial amount borrowed. The additional sum required is defined as the call premium.
Many callable bonds offer a period of call protection, which protects investors from a call just a short time after the bonds are issued. For example, the 20-year callable bonds issued by Vanguard Healthcare in 2014 are not callable until 2023, which is ten years after the original issue date. This type of call provision is known as a deferred call.
The call privilege is valuable to the issuer but potentially detrimental to bondholders, especially if the bond is issued in a period when interest rates arc cyclically high. In general, bonds are called when interest rates have fallen because the issuer usually replaces the old, high-interest issue with a new, lower-interest issue and hence reduces annual interest expense. As a result, investors are forced to reinvest the returned principal in new securities at the then current (lower) rate. Call provisions add risk to a bond investment, so in recognition of this added risk, the interest rate set on a new issue of callable bonds will be higher than that on a similar new issue of noncallable bonds.
If a bond or other debt security has a call provision and interest rates ^roP> the issuer has to make a decision, called a refunding decision, whether t0 call the issue. In essence, the decision involves a cost-benefit analysis,
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wherein the costs are the administrative costs associated with calling Orie bond and issuing another and the benefits are lower future interest payments
Sinking Funds A sinking fund- is a provision that provides for the systematic retirement of a bond issue. Typically, sinking fund provisions require the issuer to retire (i.c redeem) a portion of the issue each year. (A serial issue of municipal bonds can be thought of as a type of sinking fund.)
On some occasions, the issuer of bonds with a sinking fund may be required to deposit money with a trustee, which invests the funds and then uses the accumulated sum to retire the entire bond issue when it matures. Sometimes the stipulated sinking fund payment is tied to the level of revenues or earnings in each year, but usually it is a mandatory fixed amount. If it js mandatory, a failure to meet the sinking fund requirement places the issue in technical default.
Although a sinking fund is designed to protect the bondholders by ensuring that the issue is retired in an orderly fashion, it must be recognized that, like a call provision, a sinking fund may at times work to the detriment of bondholders. However, securities that provide for a sinking fund are regarded as being safer than those without sinking funds, and that fact tends to balance the risk of a sinking fund call. Thus, sinking fund provisions gener- ally have little effect on an issue’s interest rate.
SELF-TEST QUESTIONS 1. Describe the following debt contract features:
a. Restrictive covenant b. Trustee c. Call provision d. Sinking fund
2. What is the difference between technical default and regular default?
3. What impact does a call provision have on an issue’s interest rate? 4. How do sinking fund provisions differ from call provisions?
Bond Insurance
Bond insurance, which is one form of credit enhancement, is a means of upgrading the rating of a lower-rated bond. Here’s how it works. Regard- less of the inherent credit rating of the issuer, a separate company—the bond insurer—guarantees that bondholders will receive the promised interest and principal payments. Thus, bond insurance protects investors against default
Chapter 6 Supplement: Interest Rate Levels . . .
by the issuer. Because the insurer guarantees that payments will be made, the bond carries the credit rating of the insurance company rather than that of the issuer.
Bond insurance gives the issuer access to a lower interest rate, but not without a cost. Bond insurers typically charge an upfront fee stated as a percentage of the total debt service over the life of the bond. The lower the issuer’s inherent credit rating and the worse the outlook for the industry, the higher the cost of bond insurance. Upon careful analysis, the insurance costs on many issues appear to fully negate the value inherent in lower-interest pay- ments. Still, such “economically neutral” deals often appeal to issuers because insurance protects investors, and the reputation of the issuer, against future uncertainty. A provider with a solid rating today—say, A+—could easily fall on hard times 20 or so years down the road. Credit enhancement allows the issuer’s creditworthiness to decline without having to explain the reasons to the investment community.
Historically, about half of all municipal healthcare bond issues car- ried insurance. However, many bond insurers were caught up in the 2008 financial crisis of derivative contracts, subprime mortgages, and collateralized mortgage obligations. Every AAA-rated bond insurer was downgraded, and many were forced out of business. Today (2014), there is only one hospital bond insurer writing coverage on new issues (Assured Guaranty Corporation, with a rating of AA-).
Instead of commercial bond insurance, many hospitals have turned to federal hospital mortgage insurance (FHA 242) provided by the Federal Housing Administration (FHA), a part of the Department of Housing and Urban Development. Since 1968, the FHA 242 program has insured nearly $20 billion in hospital loans used for facilities construction. Hospitals with more than 50 percent of patient days attributable to acute care are eligible for FHA insurance on both taxable and tax-exempt debt with fixed interest rates having maturities of up to 25 years after construction completion. FHA 242 debt is the equivalent of at least an AA rating, which is higher than most hospitals’ inherent rating.
1. Explain the concept of bond insurance. 2. What is the FHA 242 program?
SELF-TEST QUESTIONS
Debt Refunding
If a debt issue is callable, and if interest rates drop, the issuer may elect to lower its interest expense by issuing new debt and using the proceeds to call (retire) the existing issue. This action is called refunding. Costs are involved
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in refunding, but there is one major benefit: The issuer reduces the dollar amount of interest payments that it must make in the future. Thus, a refund- ing analysis is a classical application of discounted cash flow cost-benefit analysis—the issuer should refund the bond if the present value of the refund- ing savings exceeds the present value of the costs of refunding.
The easiest way to examine the refunding decision is through an exam- ple. Suppose Minnesota Health Systems (MHS), Inc., an investor-owned corporation, has a $60 million bond issue outstanding that has a 15 percent annual coupon and 20 years remaining to maturity. This 30-year issue (which was sold ten years ago) had flotation costs of $3 million (which MHS has been amortizing on a straight-line basis over the 30-year original life of the issue). (Flotation costs are the printing, accounting, legal, and investment banker expenses associated with new securities issues.) The bond has a call provision with a ten-year call deferral, so the bond can now be called, but a 10 percent call premium is required. MHS’s investment bankers have indi- cated that the system can sell a new $60-$70 million issue of 20-year annual coupon bonds at an interest rate of 12 percent. (We are using annual coupon bonds to simplify the mathematics of the illustration. The same techniques, with minor modification, would be applied to semiannual coupon bonds.) Flotation costs on a new issue would amount to $4 million. MHS’s marginal federal-plus-state tax rate is 40 percent. Should MHS refund the $60 million of 15 percent bonds?
The following steps outline the decision process; the steps are sum- marized in tabular form in Exhibit S6.2.
1. Calculate the investment outlay required to refund the issue. a. Call premium on the old issue.
Before tax: 0.10 x $60,000,000 = $6,000,000.
After tax: $6,000,000 x (1 - T) = $6,000,000 x 0.60 = $3,600,000.
Although MHS must spend $6 million on the call premium, this expense is tax deductible in the year the call is made. Because the firm is in the 40 percent marginal tax bracket, it saves 0.40 x $6,000,000 = $2,400,000 in taxes, for an after-tax cost of only $3,600,000. This amount is shown as a cost, or outflow, in line 1 of Exhibit S6.2.
b. Flotation costs on the new issue. Flotation costs on the new issue are $4 million, as shown in line 2 of the worksheet. For tax purposes, flotation costs must be amortized, or spread, over the 20-year life of the new bond and then used to reduce taxable income in each year. The amortization cash flows will be discussed later.
Chapter 6 Supplement: Interest Rate Levels . . . 271
Amount Before Tax
Amount After Tax
Present Value at 7.2%
Investment Outlay att = o i. Call premium on the old
issue ($6,000,000) ($3,600,000) ($ 3,600,000) 2. Flotation costs on new
issue (4,000,000) (4,000,000) (4,000,000) 3. Tax savings on old
issue flotation costs 2,000,000 800,000 800,000 4. Net investment outlay Annual Flotation Cost Tax Effects 5. Benefit from new issue
flotation costs $ 200,000 $ 80,000
($ 6,800,000)
$ 834,505 6. Lost benefit on old issue
flotation costs (100,000) (40,000) (417,252) 7.Present value of amortization
tax effects
Savings Due to Refunding 8. Interest payment on
old issue $9,000,000 $5,400,000
$ 417,253
9. Interest payment on new issue 7,200,000 4,320,000
10. Net interest savings $1,080,000 $ 11,265,817 NPV of Refunding Decision 11. NPV $ 4,883,070
EXHIBIT S6.2 Bond Refunding Worksheet
apter 6 Supplem ent
c. Flotation costs on the old issue. The flotation costs on the old issue were amortized and deducted from taxable income, just as we will do on the new-issue flotation costs. However, if the refunding takes place, tax laws permit MHS to immediately expense the portion of the old-issue flotation costs that has not yet been expensed. Because ten years have passed since the old 30-ycar bond was originally issued, only one-third of the $3 million flotation costs have been expensed for tax purposes, leaving two-thirds, or $2 million, unexpensed. This immediate deduction from taxable income would create a 0.40 x $2,000,000 = $800,000 tax savings, or inflow, which is shown in line 3.
d. Total after-tax investment outlay. The total investment outlay required at Time 0 to refund the bond issue is $6,800,000, which is shown in line 4.
2 Determine the net effect of flotation cost amortization. a. New issue flotation cost amortization. With total flotation costs of
$4 million on the new issue, the annual taxable income deduction
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is $4,000,000/20 = $200,000. Because MHS is in the 40 percent tax bracket, it has a tax savings of 0.40 x $200,000 = $80,000 pcr year for 20 years. In a refunding analysis, all cash flows must be discounted at the after-tax cost of new debt, which is 12% x (1 -J-J = 12% x 0.6 = 7.2%. The present value of the new issue flotation cost tax savings, when discounted at 7.2 percent, is $834,505, which is shown as a savings, or inflow, in line 5. As in all cases, the primary consideration in choosing a discount rate is the riskiness of the cash flow stream. In a bond refunding, the cash flows are relatively safe because they are fixed by contract, so a relatively low discount rate should be chosen. What market rate reflects relatively low risk? The answer is the rate of return required on MHS’s bonds, so it is chosen as the basis for the discount rate used in the refunding analysis. b. Old issue flotation cost amortization. If the refunding takes place, MHS loses the opportunity to continue to expense the old flotation costs over time, so the $2,000,000/20 = $100,000 reduction in annual taxable income is lost. Thus, MHS loses the annual tax savings of 0.40 x $100,000 = $40,000 for the next 20 years. The present value of these lost savings, which is an opportunity cost of refunding, is $417,252, which is shown in line 6. Note that because of the refunding, the remaining old flotation costs provide the immediate tax savings shown in line 3 rather than the annual savings shown in Line 6. Thus, the $800,000 - $417,252 = $382,748 net savings simply reflect the difference between the present value of tax benefits to be received in the future without the refunding versus the immediate benefit if the refunding takes place.
c. Total amortization effect. The net effect of the amortization of flotation costs on the old and new debt issues is $417,253 on a present value basis. This amount is shown in Line 7.
3. Calculate the annual interest savings. a. Interest expense on old issue. The annual after-tax interest on the old
issue is $5,400,000, which is shown in line 8: 0.15 x $60,000,000 x 0.60 = $5,400,000.
b. Interest expense on new issue. The annual after-tax interest on the new issue is $4,320,000, which is shown in line 9: 0.12 x $60,000,000 x 0.60 = $4,320,000.
c. Annual interest savings. The annual interest savings is $1,080,000, which is shown in line 10: $5,400,000 - $4,320,000 = $1,080,000.
d. Present value of annual savings. The present value of $1,080,000 per year for 20 years, when discounted at 7.2 percent, is $11,265,817. This amount is also shown in line 10.
Chapter 6 Supplement: Interest Rate Levels . .
4. Calculate the net present value (NPV) of the refunding.
Net investment outlay
Amortization tax effects
Interest savings
NPV of refunding
Because the NPV of the refunding is positive, it would be profitable for MHS to refund the old bond issue.
However, several additional points should be noted. First, because the refunding is advantageous to MHS, it must be disadvantageous to bondhold- ers; they must give up their 15 percent bonds and reinvest the proceeds in securities that have a lower interest rate. This situation illustrates the danger of a call provision to bondholders, and it also explains why bonds without a call provision have lower interest rates than callable bonds have.
Second, although it is not emphasized in the example, we assumed that the firm raises the investment required to undertake the refunding operation (the $6,800,000 shown in line 4) as debt. Typically, businesses raise the investment outlay by increasing the amount of the new issue, which is easily done because the new issue has a lower interest rate; hence, they can borrow additional principal. In this example, MHS might sell $67 million of new bonds.
Third, we set up the example so that the new issue had the same matu- rity as the remaining life of the old issue. Often, the old bonds have only a relatively short term to maturity (say, five to ten years), while the new bonds have a longer maturity (say, 25 to 30 years). In this situation, a replacement chain analysis is required. (See Chapter 11 for an example of a replacement chain [common life] analysis.)
Fourth, not-for-profit firms conduct refunding analyses in the same way as that presented in Exhibit S6.2. The only difference is that the tax rate is zero, so there are no direct tax effects to consider in the analysis. Finally, although the analysis shows that the refunding would be prof- itable now, it might be even more profitable if MHS waits and refunds later, as interest rates could fall further. The mechanics of calculating the NPV of refunding is relatively simple, but the decision on when to refund is not simple because it requires a forecast of future interest rates. Thus, the tim- ing decision is more a matter of judgment than of quantitative analysis. To illustrate, assume that MHS’s managers forecast that long-term interest rates have a 50 percent probability of remaining at their present level of 12 per- cent over the next year. However, there is a 25 percent probability that rates could fall to 10 percent, and a 25 percent probability that rates could rise to U percent. The refunding analysis could then be repeated, but this time we
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EXHIBIT S6.3 Interest RateProbability Interest Rate
NPV of Refunding One Year from Now
and Bond25% 10% $13,737,916^ Refunding50 12 4.607,124
Forecast25 U (3.067,344)
would assume that the refunding would take place one year from now when the old bonds have only 19 years to maturity. (We would also assume that the new issue would have a 19-year maturity.) We performed the analysis and found the NPV distribution one year from now, as shown in Exhibit S6.3.
Note that if rates rose to 14 percent next year, the NPV of refunding would be negative, so MHS would not refund the issue and the realized NPV at a 14 percent interest rate would be $0. Thus, the expected NPV of refund- ing next year is $5,738,041, versus $4,883,070 if refunding takes place now:
(0.25 x $13,737,916) + (0.50 x $4,607,124) + (0.25 x $0) = $5,738,041.
Even though the expected NPV of refunding in one year is higher, MHS’s managers would probably decide to refund today. Here’s why: First, the $5,738,041 NPV must be discounted back one year to make it com- parable to the NPV of an immediate refunding. Using a discount rate of 10 percent, the NPV of refunding in one year drops to $5,216,401. More important, the NPV of refunding in one year is only an expected NPV because it depends on future interest rates, while the NPV of refunding today is known with some certainty. MHS’s managers would opt to delay the refunding only if the expected NPV of refunding later is sufficiently above the NPV of refunding now to compensate for the risks involved.
Clearly, the timing decision is complicated by the fact that there would be numerous opportunities to refund in the future rather than just a single opportunity one year from today. Furthermore, the decision must be based on a large set of interest rate forecasts, which is in itself a daunting task to complete. Fortunately, managers who make bond refunding decisions are advised by sophisticated investment bankers who can now use the values of derivative securities to estimate the value of a bond’s embedded call option. If the call option is worth more than the NPV of refunding today, the issue should not be immediately refunded. Rather, the issuer should either delay the refunding to take advantage of the information obtained from the deriva- tive market or create a derivative transaction to lock in the value of the call option. (We introduce options and their use in financial risk management in online Chapter 18.)
Chapter 6 Supplement: Interest Rate Levels . . .
1. Briefly describe the mechanics of a bond refunding analysis. 2. Why is the timing decision so difficult to make?
SELF-TEST QUESTIONS
Economic Factors That Influence Interest Rate Levels
The general level of interest rates, as opposed to the rate set on a particu- lar debt issue, and the shape of the yield curve are influenced by economic factors. The three most important of these factors are (1) Federal Reserve Board policy, (2) federal budgetary policy, and (3) the overall level of busi- ness activity.
Federal Reserve Board Policy The money supply has a significant effect on the level of economic activity and the inflation rate and, hence, on the level of interest rates. In the United States, the money supply, along with short-term interest rates, is controlled by the Federal Reserve Board. If the Fed wants to stimulate the economy, it increases the growth of the money supply and lowers the short-term inter- est rate that banks charge one another to borrow funds. Alternatively, if the Fed believes that the economy is overheated and inflation will be a problem in the future, it tightens (reduces) the money supply and raises short-term rates. During periods when the Fed is actively intervening in the credit markets, interest rates are affected and the yield curve may be temporarily distorted—that is, short-term rates may be temporarily “too high” or “too low.” Typically, the impact of the Fed’s actions on short-term interest rates is much greater than on long-term rates.
Federal Budgetary Policy If the federal government spends more than it receives in tax revenues, it runs a deficit. Typically, the shortfall is covered by government borrowing (issuing Treasury securities), which increases the supply of debt capital and hence raises the general level of interest rates. The relative impact on short- term and long-term rates depends on how the deficit is financed. Reliance on short-term debt raises short-term rates, while reliance on long-term debt increases long-term rates. Over the past several decades, the federal govern- ment has—except for a few years—had an annual deficit, which has pushed the national debt in 2014 to more than $18 trillion. (Current information about the size of the national debt, as well as related statistics, can be found at www.usdebtclock.org.) Clearly, federal borrowings have exerted upward pressure on the overall level of interest rates. Because the government uses
276 Understanding Healthcare Finance Management
both short- and long-term borrowing to finance its deficits, the impact of budgetary policy on the yield curve is uncertain.
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Overall Level of Business Activity Business conditions have a significant effect on interest rates. Consumer demand slows during recessions and low-growth periods, which means that fewer goods and services are sold, especially durable goods (houses, automo- biles, and the like). Companies hire fewer employees and spend less on new capital assets (land, buildings, and equipment). The net result is downward pressure on inflation, on the demand for borrowed funds, and hence on interest rates. At the same time, the Fed is trying to stimulate the economy by increasing the money supply and lowering short-term rates. In general these conditions tend to have more of an impact on short-term rates than on long-term rates because (1) the Fed operates in the short end of the credit markets and (2) long-term inflation expectations are not as volatile as short- term expectations. The story is reversed when the economy is booming.
SELF-TEST QUESTIONS
Chapter 6 Supplement: Interest Rate Levels . . . 277
• Sometimes a borrower will find that it is necessary to borrow on a secured basis, in which case the borrower uses assets—such as real estate, securities, equipment, inventories, or accounts receivable— as collateral for the loan.
• Restrictive covenants are placed in loan agreements to protect creditors from detrimental actions by borrowers.
• A call provision gives the issuer the right to redeem the bonds prior to maturity under specified terms, usually at a price greater than the maturity value (the difference is a call premium). A firm will call a bond issue and refund it if interest rates fall sufficiently after the bond has been issued.
• A sinking fund is a provision that requires the issuer to retire a portion of the bond issue each year. The purpose of sinking funds is to retire issues in an orderly manner. No call premium is paid to the holders of bonds called for sinking fund purposes.
• Credit enhancement, or bond insurance, upgrades a municipal bond rating to AAA. Regardless of the issuer’s inherent credit rating, the bond insurer guarantees that bondholders will receive the promised interest and principal payments.
• The general level of interest rates is influenced by several economic factors, including (1) Federal Reserve Board policy, (2) federal budget policy, and (3) the overall level of business activity.
• If a debt issue is callable, and if interest rates drop, the issuer may elect to lower its interest expense by issuing new debt and using the proceeds to call (retire) the existing issue. This action is called a refunding.
• A refunding analysis is a classic application of discounted cash flow cost-benefit analysis—the issuer should refund the bond if the present value of the refunding savings exceeds the present value of the costs of refunding.
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EQUITY FINANCING 7 Learning Objectives After studying this chapter, readers should be able to
• explain the rights and privileges associated with common stock ownership,
• discuss the different methods by which new common stock is sold, • describe the market for common stock, • explain how not-for-profit businesses obtain “equity” financing, • value stocks and calculate their expected rates of return, and • explain the concept of market efficiency and its implications for
investors and managers.
Introduction
Debt financing concepts were discussed in Chapter 6, including how interest rates are set in the economy, types of debt, and how various debt features affect the interest rate on any particular issue. The second major source of capital for healthcare businesses is equity financing. Proprietorships and part- nerships raise equity capital through owner contributions, while for-profit corporations obtain equity financing through the sale of stock. For-profit businesses also obtain equity capital by retaining earnings. Not-for-profit corporations raise equivalent financing—sometimes called fund capital— through contributions and grants and by retaining earnings. From a financial perspective, common stock and fund financing serve the same basic purpose, so the generic term equity is used to refer to all non-debt capital, regardless of a business’s ownership.
In this chapter, we discuss the same general issues as presented in Chapter 6, but the focus is on equity financing. Like debt financing, there are many different types of equity with many different features. If we were to discuss all of these features, along with the methods for selling stock to investors, this chapter would be too long to be manageable. Thus, the chap- ter focuses on key issues, while the Chapter 7 Supplement (see the end of this chapter) contains material that is useful and relevant but not essential to understanding the fundamentals of equity financing.
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Rights and Privileges of Common Stockholders
Common stockholders are the owners of for-profit corporations and as such have certain rights and privileges. The most important of these rights and privileges are discussed in this section.
Claim on Residual Earnings The reason most people buy common stocks is to gain the right to a pro- portionate share of a corporation’s residual earnings. A corporation’s net income, which is the residual earnings after all expenses have been paid belongs to the common stockholders. For many corporations—particularly mature ones—some portion of net income will be paid out to common stockholders as dividends. Although the predominant timing of dividend payments is quarterly, some corporations are now changing to annual divi- dends to reduce the administrative costs associated with such payments. The portion of net income that is retained within the business will be invested in new assets, which presumably will increase the business’s earnings over time and hence contribute to even greater dividends in the future.
An increasing dividend stream means that the stock will be more valu- able in the future than it is today because dividends will be higher—say, in five years—than they are today. Thus, common stockholders typically expect to be able to sell the stock they purchased at some time in the future at a price higher than they paid for it and hence realize a capitalgain. For an illustra- tion of the payment of dividends, consider Exhibit 7.1, which lists the annual per share dividend payment and earnings, as well as the average annual stock price, for Big Sky Healthcare from 2004 through 2014. Over the ten growth periods, Big Sky’s dividend grew by 275 percent, or at an average annual growth rate of 14.1 percent. At the same time, the firm’s stock price grew by 247 percent, which equates to an average annual growth rate of 13.2 percent.
EXHIBIT 7.1 Big Sky
Healthcare: Dividends,
Earnings, and Stock Price,
2004-2014
Year Annual per Share
Dividend Annual per Share
Earnings Average Annual
Stock Price
2004 $0.20 $0.48 $ 7-70 2005 0.23 0.55 w.95 2006 0.23 0.52 11.00 2007 0.23 0.58 10.40 2008 0.48 0.85 15-30 2009 0.52 1.10 18.70 2010 0.58 1-25 20.60 2011 0.58 0-45 19-50 2012 0.65 1-35 23.20 2013 0.70 1.50 24.40 2014 0.75 1-55 26.70
Chapter 7: Equity Financing 281
Note that Big Sky’s dividend growth was not a constant 14.1 percent each year. Many corporations hold the dividend constant for several years to allow earnings to climb to a point where they can support a higher dividend payment. For example, Big Sky kept its dividend at $0.23 a share from 2005 through 2007, while earnings per share were flat at about $0.55.
In general, managers are reluctant to reduce dividends because inves- tors interpret lower dividends as a signal that management forecasts poor times ahead. Thus, when Big Sky saw its earnings per share tumble from $1.25 in 2010 to $0.45 in 2011, it maintained its $0.58 per share dividend. Big Sky was able to pay a cash dividend that exceeded earnings in 2011 because the firm’s cash flow, which is roughly equal to net income plus depreciation, easily supported the dividend. When earnings picked up again in 2012, Big Sky increased its dividend to $0.65.
Over the entire period, Big Sky proved to be an excellent investment for stockholders. For example, assume that you bought the stock for $7.70 in 2004, received a $0.20 dividend payment, and then sold the stock one year later for $10.95. For simplicity, assume that the dividend payment was paid at the end of the one-year holding period rather than quarterly. Thus, you paid $7.70, and one year later you received $10.95 + $0.20 = $11.15. The total return earned was Total profit/Amount of investment = ($11.15 - $7.70)/$7.70 = 0.448 = 44.8%. Note, however, that investors who bought Big Sky’s stock in 2006 or 2010 and then sold it one year later would have had a capital loss—rather than a capital gain—on the sale. Of course, they would have received quarterly dividends over the one-year holding period. We will have much more to say about stock valuation later in the chapter. Also, for more information about corporate dividend policy as well as other distributions, see Chapter 17 (Distributions to Owners: Bonuses, Dividends, and Repurchases), which is available exclusively online at ache.org/books/ UHFM7.
Control of the Firm Common stockholders have the right to elect the board of directors, who in turn elect the officers who will manage the corporation. In small, privately owned corporations, the major stockholders typically assume all of the man- agement leadership positions. In large, publicly owned firms, managers typi- cally have some stock, but their personal holdings are insufficient to allow them to exercise voting control. Thus, the management of most publicly owned corporations can be removed by the stockholders if they decide a management team is not effective.
Various state and federal laws stipulate how stockholder control is to be exercised. First, corporations must hold an election of directors peri- odically—usually once per year, at an annual meeting. In many corporations, one-third of the directors are elected each year for a three-year term. Each
282 Understanding Healthcare Finance Management
share of stock has one vote; thus, the owner of 1,000 shares has 1,000 votes1
Stockholders can appear at the annual meeting and vote in person, but tvpi cally they transfer their right to vote to a second party by means of a proxy Management always solicits stockholders’ proxies and usually gets them However, if the common stockholders are dissatisfied with current manage ment, an outside group may solicit the proxies in an effort to overthrow- management and take control of the business. This is known as a proxy In addition, one corporation can take over another by purchasing a major- ity of the outstanding stock. A hostile takeover occurs when such a control change takes place without approval by the board of directors of the business being bought.
Obviously, managers who do not have majority control are concerned about proxy fights and hostile takeovers. One of the most common tactics to thwart hostile takeovers is to place a poison pill provision in the corporate charter. A poison pill typically permits stockholders of the corporation that is taken over to buy shares of the resulting business entity at a greatly reduced price. Obviously, shareholders at the acquiring business do not want an out- side group to get bargain-priced stock, so such provisions effectively stop hostile takeovers. Although poison pill provisions of this type might appear to be illegal, they have withheld many court challenges. The ultimate effect of poison pills is to force acquiring firms to get the approval of the board of directors of the target firm prior to the takeover. Although the stated reason for poison pills is to protect shareholders against a hostile takeover at a price that is too low, many people believe that they protect entrenched manage- ments as least as much as stockholders.
The Preemptive Right Common stockholders often have the right—called the preemptive right—to purchase any new shares sold by the corporation. In some states, the preemp- tive right is mandatory; in others, it can be specified in the corporate charter.
The purpose of the preemptive right is twofold. First, it protects cur- rent stockholders’ position of control. Without this safeguard, the manage- ment of a corporation under criticism from stockholders could secure its position by issuing and then purchasing a large number of additional shares. Management would thereby gain a controlling position in the corporation and frustrate the outside stockholders.
Second, and more important, it protects stockholders against dilution of value. For example, suppose HealthOne HMO has 1,000 shares outstand- ing at a price of $100 per share, so the total market value of the firm is $100,000. If an additional 1,000 shares were sold at $50 a share, bringing in an additional $50,000, the total market value of HealthOne’s stock would theoretically increase to $150,000. When the new total market value is
Chapter 7: Equity Financing 283
divided by the new number of shares outstanding, the value per share drops to $75 - HealthOne’s original stockholders would lose $25 per share, and the new stockholders would realize an instant profit of $25 per share. Thus, sell- ing common stock at a price below the current market price dilutes its value and, at the same time, transfers wealth from the current stockholders to those who purchase the new shares. The preemptive right prevents such wealth transfers.
1. In what forms do common stock investors receive returns? 2. How do common stockholders exercise their right of control? 3. What is the preemptive right, and what is its purpose?
SELF-TEST QUESTIONS
Selling New Common Stock
New stock usually is sold to raise equity capital, however new stock some- times is issued without raising new capital. For example, new stock may be distributed to current shareholders when a portion of the company, usually a subsidiary, is divested (given) to shareholders in a spin-off. When stock is issued to raise new equity capital, the new shares may be sold in one of six ways:
1. On a pro rata basis to existing stockholders through a rights offering 2. Through investment bankers to the general public in a public offering 3. To a single buyer, or a very small number of buyers, in a private
placement 4. To employees through an employee stock purchase plan 5. Through a dividend reinvestment plan 6. Through a direct purchase plan
The following sections provide more information on these methods.
Rights Offering As discussed earlier, common stockholders often have the preemptive right to purchase any additional shares sold by the firm. If the preemptive right is contained in the firm’s charter, the firm must offer any newly issued common stock to existing stockholders. If the charter does not prescribe a preemptive right, the firm can choose to sell to its existing stockholders or to the public at large. If it sells to the existing stockholders, the stock sale is called a rights offering. Each stockholder is issued an option to buy a certain number of new shares at a price below the existing market price, and the terms of the option
284 Understanding Healthcare Finance Management
are listed on a certificate called a stock purchase right, or simply a right if stockholder does not wish to purchase additional shares in the firm, he ca ’ sell the rights to some other person who does want to buy the stock.
Public Offering If the preemptive right exists in a firm’s charter, it must sell new stock,
through a rights offering. If the preemptive right does not exist, the firni may choose to offer the new shares to the general public through a public offering. We discuss procedures for public offerings in detail in the Chapter 7 Supplement.
Private Placement In a private placement, also called a direct placement, securities are sold to one
or just a few investors—generally institutional investors. Private placements are most common with bonds, but they also occur with stocks. The primary advantages of private placements are lower issuance costs and greater speed because the shares do not have to go through the Securities and Exchange Commission (SEC) registration process.
The primary disadvantage of a private placement is that, because they have not been registered with the SEC, the securities must be sold initially to an “accredited” investor—usually a bank, insurance company, mutual fund, or pension fund. Furthermore, in the event that the original purchaser wants to sell the securities, they must be sold to other accredited investors, including individuals with a net worth of $1,000,000 or income exceeding $200,000. Because there are thousands of institutions and millions of indi- viduals that are considered by the SEC to be accredited investors, private placements now play an important role in capital acquisition, especially when smaller amounts, say, less than $50 million of capital, are being raised.
To illustrate a private placement, consider the 2014 equity sale by HealthEdge Software, a provider of cloud-based and on-site integrated finan- cial, administrative, and clinical platforms for healthcare payers. HealthEdge raised $30 million ($28.2 million after brokerage fees) in equity from the sale. In total, the company has raised almost $70 million through private unregistered securities offering. According to a company spokesman, the funds will be used to support future growth.
Employee Purchase and Employee Stock Ownership Plans Many firms have plans that allow employees to purchase stock on favorable
terms. First, under executive incentive stock option plans, key managers are given options to purchase stock. These managers generally have a direct, material influence on the firm’s fortunes, so if they perform well, the stock price will go up and the options will become valuable. Second, there are plans
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for lower-level employees. For example, Texas HealthPlans, Inc., a regional investor-owned HMO, permits employees who are not participants in its stock option plan to allocate up to 10 percent of their salaries to its stock purchase plan, and the funds are then used to buy newly issued shares at 85 percent of the market price on the purchase date. Often the firm’s contribution—in this case, the 15 percent discount—is not vested in an employee until five years after the purchase date. Thus, the employee cannot realize the benefit of the firm’s contribution without working an additional five years. This type of plan is designed both to improve employee performance and to reduce turnover.
Third, under an employee stock ownership plan (ESOP), the stock is purchased for employees out of a share of the firm’s profits. In an ESOP, firms can claim a tax credit equal to a percentage of wages, provided that the funds are used to buy newly issued stock for the benefit of employees. Because ESOPs enjoy favorable tax treatment, and because they are thought to create a more loyal and productive workforce, many firms have created such plans in recent years. Now, around 11,300 firms have ESOPs that cover 13 million employees.
Dividend Reinvestment Plan During the 1970s, many large corporations instituted dividend reinvestment plans (DRIPs), whereby stockholders can automatically reinvest their divi- dends in the stock of the paying corporation. There are two types of DRIPs: (1) plans that involve only “old” stock that is already outstanding, and (2) plans that involve newly issued stock. In either case, the stockholder must pay income taxes on the amount of the dividends even though stock, rather than cash, is received.
Under both types of DRIPs, stockholders must choose between con- tinuing to receive cash dividends and using the cash dividends to buy more stock in the corporation. Under the “old” stock type of plan, a bank, which acts as a trustee, takes the total funds available for reinvestment from each quarterly dividend, purchases the corporation’s stock on the open market, and allocates the shares purchased to the participating stockholders on a pro rata basis. The brokerage costs of buying the shares are low because of volume purchases, so these plans benefit small stockholders who do not need cash for current consumption.
The “new” stock type of DRIP provides for dividends to be invested in newly issued stock; hence, these plans raise new capital for the firm. No fees are charged to participating stockholders, and some firms offer the new stock at a discount of 3 to 5 percent below the prevailing market price. The firms absorb these costs as a trade-off against the issuance costs that would be incurred if the stock were sold through investment bankers rather than through the DRIP.
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Direct Purchase Plan In recent years, many corporations have established direct purchase plans which allow individual investors to purchase stock directly from the firn/ Many of these plans grew out of DRIPs, which were expanded to allow participants to purchase shares in addition to those purchased through the DRIPs. In direct purchase plans, investors usually pay nominal or no broker- age fees, and many plans offer convenient features such as fractional share purchases, automatic purchases by bank debit, and quarterly statements.
Although employee purchase plans, DRIPs, and direct purchase plans are an excellent way for employees and individual investors to purchase stock they typically do not raise large sums of new capital for the business, so other methods must be used when equity needs are great.
SELF-TEST QUESTIONS 1. What is a rights offering?
2. What is a private placement, and what are its primary advantages over a public offering?
3. Briefly, what is an employee stock purchase plan? 4. What is a dividend reinvestment plan? 5. What is a direct purchase plan?
The Market for Common Stock
Some corporations are so small that their common stock is not actively traded; rather, they are owned by only a few people who usually are the man- agers. Such firms are said to be privately held, or closely held, and the stock is said to be a closely held stock.
The stocks of most small, publicly owned corporations are not listed on an exchange and hence are called unlisted. Such stocks trade in the over- the-counter (OTC) market, which consists of a network of dealers connected by computer. The roughly 10,000 companies that are traded in the OTC market usually are highly risky and typically do meet the standards required to be accepted on an exchange.
Most large, publicly owned corporations are listed on one of the stock exchanges—either the NASDAQ (which formerly stood for the National Association of Securities Dealers Automated Quotations) or the “Big Board” (the New York Stock Exchange [NYSE]). For example, CareDX, Inc.— which develops noninvasive diagnostic equipment used to monitor organ transplant patients—was listed on the NYSE in 2014. About 3,000 stocks are listed on the NASDAQ exchange, while roughly 2,000 are listed on the NYSE, but because of the larger size of its listed firms, the NYSE historically has dominated the NASDAQ in terms of the market value of stocks listed.
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To have its stock listed on an exchange, a corporation must meet the ^change’s minimum requirements regarding size, number of shareholders, md number of shares held by outsider investors, which is called flout. Float is important to an exchange because shares held by insiders trade much less frequently than do shares held by outsiders. If the float is small, there will be limited trading, and the exchange, as well as investors, will gain little from
the listing. Many people believe that listing is beneficial to both the firm and its
stockholders. Listed firms receive a certain amount of free advertising and publicity, and their listed status may enhance their prestige and reputation. These factors, as well as the safeguards against illegal trading practices, may have a positive impact on sales and stock price. However, improvements in telecommunications and digital processing of trades have lowered transaction costs to the point where differences between trading on an exchange and on the OTC market arc inconsequential. Furthermore, listing on an exchange does not add much cachet to large firms with well-recognized names.
Institutional investors—such as pension funds, insurance firms, and mutual funds—own about 60 percent of all common stocks. However, the institutions buy and sell relatively actively, so they account for about 75 per- cent of all transactions. Thus, the institutions have the greatest influence on the prices of individual stocks.
Stock market transactions can be classified into three categories:
1. The new issue market. A small firm typically is owned by its management and a handful of private investors. At some point, if the firm is to grow further, its stock must be sold to the general public, which is defined as going public. The market for stock that is in the process of going public is often called the WCTP issue market, and the issue is called an initial public offering (IPO). For example, in February 2014 Inogen, Inc.—a medical technology company that develops, manufactures, and markets innovative portable oxygen concentrators— raised close to $50 million (after expenses) in an IPO by selling more than 4 million shares at $16 per share.
2. The primary market. Also in February 2014, Five Prime Therapeutics, Inc.—a biotechnology company focused on discovering and developing novel protein therapeutics—sold 3 million shares of new common stock at a price of $12.50 per share for an aggregate offering of $37.5 million, before underwriting discounts, commissions, and estimated expenses. Because the shares sold were newly created, the issue was defined as a primary market offering; but because the business was already publicly held, the offering was not an IPO. Corporations prefer to obtain equity by retaining earnings because of the issuance costs and market pressure associated with the sale of new
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common stock. Still, if a firm requires more equity funds than can b- generated from retained earnings, a stock sale may be necessary
3. The secondary market. If the owner of 100 shares of Tenet Healthcare sells her stock, the trade is said to have occurred in the secondary market. Thus, the market for outstanding, or used, shares is defined as the secondary market. More than 1.5 million shares of Tenet were bought and sold daily on the NYSE in 2014, but the firm did not receive a dime from these transactions.
SELF-TEST QUESTIONS 1. What is an IPO?
2. What is the difference between selling Tenet shares in the primary market and selling the firm’s shares in the secondary market?
3. What is the difference between a listed stock and an unlisted stock?
The Decision to Go Public
Most businesses start as proprietorships or partnerships, and then if they are successful and grow, they find it useful to convert to a corporation. Initially, the stock of most corporations is owned by the business’s founders, key employees, and often a few investors—usually venture capitalists—who may or may not be actively involved in management.2 However, if growth contin- ues, at some point most firms go public. The advantages and disadvantages of public stock ownership are discussed next.
Advantages of Going Public • Permits founder diversification. As a business grows and becomes
more valuable, its founders often have most of their wealth tied up in their ownership position. By selling some of their stock during the IPO or sometime thereafter, the founders can better diversify their holdings, thereby reducing the riskiness of their personal portfolios.
• Increases liquidity. The stock of a closely held firm is very illiquid: It has no ready market. If one of the owners wants to sell some shares to raise cash, it will be difficult to find a buyer, and even if one can be found, there is no established price on which to base the sale. Going public creates liquidity and solves these problems.
• Facilitates raising new corporate cash. If a privately held firm needs to raise new equity, it must either get it from the current owners, who may not want to put additional capital into the business, or
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seek outside investors. However, often the firm finds it difficult to get outsiders to contribute equity capital to a closely held business because they are at the mercy of the founders who have a controlling interest. For example, the founders, who typically are the managers, can vote themselves excessive compensation packages, have private self- serving dealings with the business, and even withhold the business’s financial information from outside investors. There are few positions as vulnerable as being an outside stockholder in a closely held firm. Going public—which requires both public disclosure and regulation by the SEC—gready reduces these problems and hence makes it much easier for the business to raise equity capital.
• Establishes a value for the business. There are several reasons why it is useful for the marketplace to establish the equity value of a business. When the owner of a closely held business dies, tax appraisers must set a value on the ownership position. If the value is too high, the estate is treated unfairly, but if the value is too low, the taxpayers lose. A firm that is publicly held has an established value. Similarly, if a firm gives incentive stock options to key employees, they cannot estimate a value for those options unless the stock is publicly traded.
• Allows private equity investors to cash out. During the 1990s and early 2000s, private equity investors purchased the stocks of many publicly owned companies, thereby converting those companies to private ownership. A prime example was the 2006 purchase of HCA (Hospital Corporation of America) by three private equity firms. At the time of the purchase, the new owners of HCA planned to “cash out” by taking the company public again at some future date after they had taken steps to increase the value of the enterprise. That transaction took place in March 2011, when HCA sold 126.2 million shares for $30 each, raising about $3.79 billion. This transaction marked the largest private-equity backed IPO in US history.
Disadvantages of Going Public • Cost of reporting. A publicly owned firm must file quarterly and annual
reports with the SEC and various state agencies. Such reports are costly to produce, especially for smaller firms that do not have the internal resources to prepare them. For example, the annual cost of complying only with the Sarbanes-Oxley Act of 2002—which specifies corporate financial reporting duties and responsibilities—can easily top $10 million.
• Disclosure. In most situations, the managers of large firms would prefer to keep operating and financial data private rather than have them available to the firm’s competitors. Similarly, the owners of
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smaller firms may not want to disclose their net worth, and because a publicly owned firm must disclose the number of shares owned by its officers, directors, and major stockholders, it is easy for anyone to estimate the net worth of the insiders—or at least the portion due to the owners of the business. For example, Select Medical Corporation which operates more than 1,000 specialty hospitals and clinics, chose to go private in 2004. The shares held by the public were purchased by management and private investors, and the company became (again) privately held. The reason given for this action was that it is “easier to operate” as a private company.
• Self-dealings. The owners/managers of closely held firms have many opportunities for various types of questionable but legal self- dealings, including the payment of above-market salaries; nepotism; personal transactions with the business, such as lease arrangements; over-granting of stock options and warrants; and other fringe benefits that go far beyond what the marketplace sets as reasonable. Such self- dealings become harder to sustain when a firm becomes public and ultimately creates a board of directors that exercises true oversight.
• Inactive market/low price. If a corporation is very small, its shares will not be frequendy traded, its stock will not really be liquid, and its market price will often be a poor measure of the stock’s value. In addition, security analysts will not follow the stock. If this situation persists, the corporation will not realize much of the benefit associated with going public.
• Control. In many businesses, the most dramatic increase in shareholder wealth occurs when a proxy fight or hostile takeover takes place. In addition, these acts motivate managers to pursue stockholder wealth maximization with some zeal. Conversely, such acts often result in removal of the managers at the acquired firm. If the managers maintain a controlling interest, their jobs are secure. In most cases, going public ultimately leads to loss of control by the founding owners/managers.
Conclusions on Going Public There are no hard and fast rules regarding when, or even if, a closely held firm should go public. This decision is different for each business and should be made on the basis of the unique circumstances surrounding the business and its stockholders. If a firm does decide to go public, either by selling new common stock to raise capital or by selling stock held by insiders, the key issue is setting the price at which the shares will be offered. The current own- ers want the price to be as high as possible because the higher the price, the smaller the proportion of the firm that they will have to relinquish to obtain
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a specified dollar amount of equity financing. On the other hand, potential buyers want the price set as low as possible. We will discuss the process of setting the price on an IPO in a later section.
1. What are the primary advantages of going public? 2. What are the disadvantages of going public?
SELF-TEST QUESTIONS
Advantages and Disadvantages of Common Stock Financing
In this section, we briefly discuss the advantages and disadvantages of financ- ing with common stock, with emphasis on its features as compared to debt financing.
Advantages of Financing with Common Stock • Has no fixed charges. Common stock does not obligate the business
to fixed charges. If the business does not generate sufficient earnings, it does not have to pay dividends on its common stock. Conversely, if the business uses debt financing, it must make the promised interest and principal payments regardless of the earnings it generates. If it uses preferred stock financing, dividend payments, for all practical purposes, are mandatory and the par value typically must be repaid according to a set schedule. (Preferred stock financing is discussed in the Chapter 7 Supplement.)
• Has no maturity date. Common stock has no maturity date; it is permanent capital that does not have to be “paid back.”
• Creates additional debt capacity. Because equity financing strengthens the position of creditors, common stock financing increases access to the debt markets and lowers the cost of debt financing.
• May be easier to sell. Common stock can, at times, be sold more easily than debt, especially when the firm is small and growing rapidly, which almost by definition makes it risky. It appeals to some investors because (1) it offers a higher expected rate of return than does preferred stock or debt, (2) it provides a better hedge against inflation than do fixed return securities, and (3) it has tax advantages over debt investments.3
disadvantages of Financing with Common Stock • Dilutes control. The sale of common stock normally gives voting
rights to new investors, which dilutes the control of current owners. For this reason, equity financing often is not used unless absolutely
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necessary by small firms whose owners/managers are unwilling to shar control with outsiders. However, as we discussed in a previous section a special class of common stock can be used that docs not confer voting rights.
• Dilutes value. Debt financing has a fixed cost, so creditors do not share in the success of a business beyond what is promised in the debt agreement. New common stock, however, “dilutes the equity” in the sense that there are more claims on the residual earnings of the business.
• Issuance costs. As discussed in the supplement to this chapter, the issuance (legal, accounting, and sales) costs associated with a new stock issue are higher than the costs associated with a similar-sized preferred stock or debt issue.
• Negative signaling. Investors may perceive the sale of new common stock as a negative signal, which would put downward pressure on the stock price. The reason for such an interpretation is the assumption that managers know more about future prospects for the firm than do outside shareholders. Furthermore, it typically is in the business’s best interest to issue new common stock only when it is overvalued in the marketplace. Thus, a new stock issue—especially one by mature firms with limited growth potential—can be interpreted as a signal that managers believe the stock to be overvalued.
SELF-TEST QUESTION 1. What are the advantages and disadvantages associated with
common stock financing?
Equity in Not-for-Profit Corporations
Although technically not-for-profit corporations do not use equity financing, they have equivalent financing which, on the balance sheet, is called either net assets or fund capital. Because this capital performs the same function as equity in for-profit businesses, we will refer to it here as equity.
Investor-owned corporations have two sources of equity financing: (1) retained earnings and (2) new stock sales. Not-for-profit corporations can, and do, retain earnings, but they do not have access to the equity mar- kets—that is, they cannot sell stock to raise equity capital. Not-for-profit cor- porations can, however, raise equity capital through government grants and charitable contributions. Federal, state, and local governments are concerned about the provision of healthcare services to the general population. There- fore, these entities often make grants to not-for-profit providers to offset the
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osts of services rendered to patients who mnot pay for those services. Sometimes these grants are nonspecific, but often
providers are required to offer specific services, such as neonatal intensive care to
needy infants. As for charitable contributions,
individuals, as well as businesses, are moti- vated to contribute to health services orga-
nizations for a variety of reasons, includ- ing concern for the well-being of others, the recognition that often accompanies large contributions, and tax deductibility. Because only contributions to not-for- profit corporations qualify as tax deduct- ible, this source of funding is, for all practical purposes, not available to inves- tor-owned entities. Although charitable
contributions are not a substitute for profit retentions, charitable contributions can be a significant source of fund capital. For example, the Association for Healthcare Philanthropy reported that total gifts to not-for-profit hospitals in recent years have averaged about $8 billion annually.
Most not-for-profit hospitals received their initial start-up equity capital from religious, educational, or govern- mental entities, and today some hospitals continue to receive funding from these sources. However, since the 1970s, these sources have provided a much smaller proportion of hospital funding, forcing not-for-profit hospitals to rely more on retained earnings and charitable contributions. Furthermore, federal pro- grams such as the Hill-Burton Act (which provided large amounts of funds for hospital expansion following World War II) have been discontinued, and state and local governments (which are also facing significant financial pres- sures) are finding it more and more difficult to fund grants to healthcare providers.
Finally, as we discussed in Chapter 1, there is a growing trend among legislative bodies and tax authorities to force not-for-profit hospitals to
The Green Bay Packers What do the Green Bay Packers have in common with the Mayo Clinic? It turns out that they are both not-for-profit organizations, but there is a surprising difference: The Packers have stock- holders. The Green Bay Packers, Inc. became a publicly owned, not-for-profit corporation in 1923, when the original articles of incorporation were filed with Wisconsin’s secretary of state. The corporation is governed by a board of directors and a seven-member executive committee. Today, 4.750,937 shares are owned by 112,158 stock- holders, but these shares are not like most stock. They pay no dividends and cannot be sold on the open market; they can only be sold back to the corporation at the same price at which they were purchased. Furthermore, any profits earned by the corporation must be donated to charity.
One of the more remarkable business stories in American sports, the team has been kept finan- cially viable over the years by its shareholders. Fans have come to the team’s financial rescue on several occasions, including the sale of $24 mil- lion in stock in 1998 for stadium improvements. To protect against someone taking control of the team, the articles of incorporation prohibit any person from owning more than 200,000 shares.
Even some not-for-profit healthcare corpo- rations issue stock, although it is rarely done. Typically, this form of not-for-profit corporation is used to initially finance not-for-profit clinics, whereby the physicians who will practice in the clinic contribute the start-up capital. When a phy- sician leaves the clinic, her initial capital invest- ment is returned.
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“earn” their favorable tax treatment by providing a certain amount of chari care to indigent patients. Even more severe, some cities have pressured not for-profit hospitals to make “voluntary” payments to the city to make up fOr the lost property-tax revenue. All of these trends tend to reduce the ability of not-for-profit health services organizations to raise equity capital by grants and contributions. The result is increased reliance on making money “thc old-fashioned way”—by earning it.
On the surface, investor-owned corporations appear to have a signifi. cant advantage in raising equity capital. In theory, new common stock can be issued at any time and in any amount. Conversely, charitable contributions are much less certain. The planning, solicitation, and collection periods can take years, and pledges are not always collected, so funds that were counted on may not materialize. Also, the proceeds of new stock sales may be used for any purpose, but charitable contributions often are restricted, in which case they can be used only for the designated purpose.
However, managers of investor-owned corporations do not have com- plete freedom to raise capital in the equity markets. If market conditions are poor and the stock is selling at a low price, a new stock issue can be harmful to the firm’s current stockholders. Additionally, a new stock issue can be viewed by investors as a signal by management that the firm’s stock is over- valued, so new stock issues tend to have a negative impact on the firm’s stock price. The bottom line here is that investor-owned businesses—especially those in fast-growing industries—do have a financing advantage over not-for- profit businesses. However, the advantage is not so great as to create market dominance. If the advantage were significant, we would likely find many fewer not-for-profit businesses in the healthcare sector than currently exist.
SELF-TEST QUESTIONS 1. What sources of equity' (fund capital) do not-for-profit businesses
have? 2. Do investor-owned businesses have a significant financing
advantage over not-for-profit businesses?
Common Stock Valuation
For many reasons, the valuation of the common stocks of for-profit busi- nesses is a difficult and perplexing process. Furthermore, the model used depends on the characteristics of the issuing business. For stock valuation purposes, there are three types of corporations:
1. Start-up. Start-up businesses generally pay no dividends because all earnings must be reinvested in the business to finance growth. To
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make matters worse, start-up firms often take years to make a profit, so there is no track record of positive earnings to use as a basis for a cash flow forecast. Under such conditions, traditional cash flow valuation models cannot be applied because the value of such firms stems more from potential opportunities rather than from existing product or service lines. Even if most of the opportunities do not materialize, one or two can turn into blockbusters and hence create a highly successful firm. Option pricing techniques, which we briefly introduce in online Chapter 18, can—at least in theory—be used to value the stock of such firms. In reality, such valuations are not much better than shots in the dark, so stock prices are based more on qualitative factors, including emotions, than on anything else. As a result, the stock prices of start-up businesses typically are highly volatile.
2. Earnings but no dividends. As a firm passes through its initial start-up phase, it often reaches a point where it has more or less predictable positive earnings but still requires reinvestment of these earnings, so no dividends are paid. In such cases, it is possible to first value the entire business, and then from this value derive the value of die firm’s stock. In such a valuation, the expected earnings stream is discounted, or capitalized, to find the current value of the corporation. Then, the value of the debt is stripped off to estimate the value of the common stock. 3. Dividend paying. More mature corporations generally pay a relatively
predictable dividend, so the future dividend stream can be forecasted with reasonable confidence. In such cases, the common stock can be valued on the basis of the present value of the expected dividend
stream. We illustrate this approach in the following sections.
Definitions Common stocks with a predictable dividend stream can be valued using the general valuation model discussed in Chapter 6 applied to the expected divi- dends. Before we present the model, here are some definitions:
• E(Dt) = Dividend the stockholder expects to receive at the end of Year t. Do is the most recent dividend, which has already been paid and is known with certainty; E(DJ is the first dividend expected and for valuation purposes is assumed to be paid at the end of one year; E(D2) is the dividend expected at the end of two years; and so forth. E(DJ represents the first cash flow a new purchaser of the stock will receive. Do, the dividend that has just been paid, is known with certainty, but all future dividends are expected values, so the estimate of any E(Dt) may differ among investors. (Note that stocks generally pay dividends quarterly, so, theoretically, we should evaluate them on a quarterly
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basis. However, in stock valuation, most analysts work on an annual basis because the data generally are not precise enough to warrant the refinement of a quarterly model. In recent years, a few companies have started paying annual—as opposed to quarterly—dividends. The rationale for doing so is that the administrative expenses associated with dividend payments are reduced significantly.)
• Po = Actual market price, of the stock today. • E(Pt) = Expected price of the stock at the end of each Year t. E(PQ) is
the value of the stock today, which is based on a particular investor’s estimate of the stock’s expected dividend stream and riskiness; E(PJ) js the price expected at the end of one year; and so on. Thus, whereas P
0 is fixed and identical for all investors, E(P0) will differ among investors depending on each investor’s assessment of the stock’s riskiness and dividend stream. E(P0), each investor’s estimate of the stock’s value today, can be above or below Po, the current stock price, but an investor would buy the stock only if her estimate of E(P0) were equal to or greater than Po.
• E(gt) = Expected growth rate in dividends in each future Year t. Different investors may use different E(gt)s to evaluate a firm’s stock. In reality, E(gt) is normally different for each Year t. However, the valuation process can be simplified by assuming that E(gt) is constant across time.
• R(R) = Required rate of return on the stock, considering both its riskiness and the returns available on other investments.
• E(Rs) = Expected rate of return on the stock. E(Rs) can be greater than, less than, or equal to R(Rs), but an investor would buy the stock only if his E(Rs) were equal to or greater than R(Rs). Note that E(Rs) is an expectation. For example, a return of 15 percent may be expected if Tenet Healthcare Corporation stock were purchased today. If market conditions or Tenet’s prospects take a turn for the worse, however, the realized return may end up being much lower than that expected, perhaps even negative. • E(D])/P0 = Expected dividend yield on a stock during the first year. If
a stock is expected to pay a dividend of $1 during the next 12 months, and if its current price is $10, its expected dividend yield is $l/$10 = 0.10 = 10%.
® [E(PJ - Po]/Po = Expected capital gains yield on the stock during the first year. If the stock sells for $10 today and is expected to rise to $10.50 at the end of the year, the expected capital gain is E(PJ - Po = $10.50 - $10.00 = $0.50 and the expected capital gains yield is [E(Pj) - Po]/Po = $0.50/$10 = 0.050 = 5%.
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Expected Dividends as the Basis for Stock Values In the Chapter 6 discussion of debt valuation, the value of a bond was found by adding the present value of the interest payments over the life of the bond to the present value of the bond’s maturity, or par, value. In essence, a bond’s value is the present value of the cash flows expected from the bond. The value of a stock according to the dividend valuation model is similarly found as the present value of a stream of cash flows. What are the cash flows that dividend-paying stocks provide to their holders? First, consider an investor who buys a stock with the intention of holding it in his family forever. In this situation, all the investor and his heirs will receive is a stream of dividends, and the value of the stock today is calculated as the present value of an infinite stream of dividends.
Consider the more typical case in which an investor expects to hold the stock for a finite period and then sell it. What would be the value of the stock in this case? The value of the stock is again the present value of the expected dividend stream. To understand this concept, recognize that, for any individual investor, expected cash flows consist of expected dividends plus the expected price of the stock when it is sold. However, the sale price received by the current investor will depend on the dividends some future investor expects to receive. Therefore, for all present and future investors in total, expected cash flows must be based on expected future dividends. In other words, unless a business is liquidated or sold to another concern, the cash flows it provides to its stockholders consist only of a stream of dividends; therefore, the value of a share of its stock must be the present value of that expected dividend stream.
The validity of this concept can also be confirmed by asking the fol- lowing: Suppose that an investor buys a stock and expects to hold it for one year. She will receive dividends during the year plus the value E(P1) when selling out at the end of the year, but what will determine the value of E(P1)? It will be determined as the present value of the dividends during Year 2 plus the stock price at the end of that year, which in turn will be determined as the present value of another set of future dividends and an even more distant stock price. This valuation can be continued infinitely, and the ultimate result is that the value of a stock is the present value of its expected dividend stream, regardless of the holding period of the investor who performs the analysis. Occasionally, stock shares could have additional value, such as the value of a controlling interest when an investor buys 51 percent of a firm’s outstanding stock, or the added value brought about by a takeover bid. However, in this model, the sole value inherent in stock ownership stems from the dividends expected to be paid by the corporation to its shareholders.
Investors periodically lose sight of the long-run nature of stocks as mvestments and forget that to sell a stock at a profit, they must find a buyer
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who will pay the higher price. Suppose that a stock’s value is analyzed on the basis of expected future dividends and the conclusion is that the stock’s mar ket price exceeded a reasonable value. If an investor buys the stock anyway he would be following the “bigger fool” theory of investment: The investor may be a fool to buy the stock at its excessive price, but he believes that, when ready to sell, an even bigger fool can be found.
The concept that the value of a stock is the present value of the expected dividend stream holds, regardless of the pattern of growth. It is not even necessary to project the stream for more than, say, 50 years. Because of the time value of money, dividends beyond that point contribute an insignifi- cant amount to a stock’s value today. It is generally not possible to have much confidence in dividend values projected over a 50-year period, so stock valua- tion using the dividend valuation model must be viewed as an approximation.
Constant Growth Stock Valuation Sometimes, the projected stream of dividends follows a pattern; hence, it is possible to develop a simplified (i.e., easier to evaluate) version of the divi- dend valuation model. This section discusses the most common simplifying assumption: constant growth.
Although the dividends of only a few firms grow at a constant rate, the assumption of constant growth is often made because it makes the forecasting of individual dividends over a long period unnecessary. Furthermore, many mature businesses come close to meeting constant growth assumptions. For a constant growth firm, the expected dividend growth rate is constant for all years, so E(g1) = E(g2) = E(g3) and so on, which implies that E(gt) becomes merely E(g). Under this assumption, the dividend in any future Year rmay be forecasted as E(Dt) = Do x [1 + E(g)]£, where Do is the last dividend paid, and hence known with certainty, and E(g) is the constant expected rate of dividend growth. Alternatively, each year’s dividend is E(g) percent greater than the previous dividend, so E(Dt) = E(Dt l) x [1 + E(g)].
Consider the following example. If Minnesota Health Systems (MHS), Inc., just paid a dividend of $1.82 (i.e., Do = $1.82), and if investors expect a 10 percent constant dividend growth rate, the dividend expected in one year is E(Dfy = $1.82 x (1 + 0.10) = $2.00; E(D2) is $1.82 x (1 + 0.10)2 = $2.20; and the dividend expected in five years is E(D.) = $1.82 x (1 + 0.10)5
= $2.93. This method of estimating future dividends can be used to estimate MHS’s expected future cash flow stream (i.e., the dividends) for some time into the future—say, 50 years. Then, the present values of this stream can be summed to find the value of MHS’s stock.
The Value of a Constant Growth Stock When E(g) is assumed to be constant, a stock can be valued using a simplified model called the constant growth model-.
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Key Equation 7.1: Constant Growth Model (Valuation)
, , = Dox[l+E(g)] = E(D,) 1 R(RS)-E(g) R(RS)-E(g)
where R(Rs) is the required rate of return on the stock. If Do = $1.82, E(g) = 10%, and R(RS) = 16% for MHS, the value of its stock would be $33.33:
E(PMHS): 1.82x1.10 $2.00
”0.16-0.10" 0.06 "
A B C D
1 2 $1.82 Do Last dividend payment 3 10.0% E(g) Expected growth rate 4 16.0% R(Rs) Required rate of return
5 6 7 8 $33-37 =A2*(i+A3)/(Azj-A3) (entered into cell A8)
9 10
Note a small rounding difference between the hand-calculated answer (where the first expected dividend was rounded to $2.00) and the spread- sheet solution.
For the constant growth model to be valid, the required rate of return on the stock must be greater than the constant dividend growth rate—that is, R(R) must be greater than E(g). If the constant growth model is used when R(R) is not greater than E(g), the results will be meaningless. However, for a stock to qualify as a constant growth stock, its dividends must be expected to grow at the constant growth rate forever, or at least for a very long time. Stocks can have an E(g) that is greater than R(RS) for short periods, but E(g) cannot exceed R(Rs) over the long run because a company’s growth rates are limited by general economic growth. Although the constant growth model is applied here to stock valuation, it can be used in any situation in which cash flows are growing at a constant rate.
How does an investor determine her required rate of return on a par- ticular stock, R(Rs)? One way is to use the Security Market Line (SML) of the capital asset pricing model, which we discussed in Chapter 5. Assume that MHS’S market beta, as reported by a financial advisory service, is 1.6. Also assume that the risk-free interest rate (the rate on long-term Treasury bonds) ls 5 percent and the required rate of return on the market is 12 percent.
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According to the SML, the required rate of return on MHS’s stock is 15 percent:
Key Equation 7.2: Security Market Line (SML)
R(RMHS) = RF + [R(RM) - RF] x bMHS 1
= 5% + (12% - 5%) x 1.6
= 5% + (7% x 1.6)
= 5% + 11.2% = 16.2% « 16%.
Remember, in the SML, RF is the risk-free rate; R(RM) is the required rate of return on the market, or the required rate of return on a b = 1.0 stock- and bMHS is MHS’s market beta.
A B C D
1 2 1.6 b Beta coefficient 3 5.0% RF Risk-free rate 4 12.0%R(RM) Required return on market
5 6 7
8 16.2% =A3+(A4 - A3)* A2 (entered into cell A8)
9 10
Growth in dividends occurs primarily as a result of growth in earnings per share (EPS). Earnings growth, in turn, results from a number of factors, including the inflation rate in the economy and the amount of earnings the firm retains and reinvests. Regarding inflation, if output in units is stable and if both sales prices and input costs increase at the inflation rate, EPS also will grow at the inflation rate. EPS will grow as a result of the reinvestment, or plowback, of earnings as well. If the firm’s earnings are not all paid out as dividends (i.e., if a fraction of earnings is retained), the dollars of investment behind each share will rise over time, which should lead to growth in produc- tive assets and hence growth in earnings and dividends.
In the constant growth model, the most critical input is E(g)—the expected constant growth rate in dividends. Investors can make their own E(g) estimates on the basis of historical dividend growth, but E(g) estimates are also available from brokerage and investment advisory firms.
Expected Rate of Return on a Constant Growth Stock The constant growth model can be rearranged to solve for E(R ), the expected rate of return. In the model’s normal form, R(RS) is the required rate of
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Chapter 7: Equity Financing 301
return, but when the model is transformed, the expected rate of return, f(R ), is f°und- This transformation requires that the required rate of return equal the expected rate of return, or R(RS) = E(Rs). This equality holds if the stock is in equilibrium, a condition we will discuss later in the chapter. After solving the constant growth model for E(Rs), this expression is obtained:
Key Equation 7.3: Constant Growth Model (Rate of Return)
If an investor buys MHS’s stock today for $33.33 (Po), expects the stock to pay a dividend of $2.00 one year from now [E(DJ], and expects dividends to grow at a constant rate of 10 percent in the future [E(g)], the expected rate of return on that stock is 16 percent:
$2 00 E(RMHS) = +10% = 6% +10% = 16%.
In this form, E(Rs)—the expected total return on the stock—consists of an expected dividend yield [E(D1)/P0] of 6% and an expected growth rate or capital gains yield [E(g)J of 10%.
A B C D
1 2 $33-33 Po Stock price 3 $2.00 E(Di) Next expected dividend 4 10.0% E(g) Expected growth rate 5 6 7 8 16.0% =A3/A2+A4 (entered into cell A8) 9 10
Suppose this analysis had been conducted on January 1, 2015, so Po = $33.33 is MHS’s January 1, 2015, stock price and E(Dt) = $2.00 is the dividend expected at the end of 2015. What is the value of E(PJ, the firm’s expected stock price at the end of 2015 (the beginning of 2016)? The con- stant growth model would again be applied, but this time the 2016 dividend, E(D2) = E(Dj) x [1 + E(g)] = $2.00 x 1.10 = $2.20, would be used:
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Notice that E(P}) = $36.67 is 10 percent greater than P = to, 3_ $33.33 x 1.10 = $36.67. Thus, a capital gain of $36.67 - $33.33 = $3.34 Wou]j be expected during 2015, which produces a capital gains yield of 10 percent-
. . ... Capital gain Capital gains yield =--------£ ------ - -----
Beginning price
$3.34 $33.33 = 0.100 = 10%.
If the analysis were extended, in each future year the expected capital gains yield would always equal E(g) because the stock price would grow at the 10 percent constant dividend growth rate. The expected dividend yield in 2016 (Year 2) can be found as follows:
Dividend yield = = $220 = 0.060 = 6%. y E^) $36.67
The dividend yield for 2017 (Year 3) can also be calculated; again, it would be 6 percent. Thus, for a constant growth stock, the following valua- tion conditions must hold:
• The dividend is expected to grow forever, or at least for a long time, at a constant rate, E(g).
• The stock price is expected to grow at this same rate. • The expected dividend yield is a constant. • The expected capital gains yield is also a constant and is equal to E(g). • The expected rate of return in any Year t—which is equal to the
expected dividend yield plus the expected capital gains yield (growth rate)—is expressed by this equation: E(R) = [E(Dt+1)/E(Pt)J + E(g).
The term expected should be clarified—it means expected in a sta- tistical sense. Thus, if MHS’s dividend growth rate is expected to remain constant at 10 percent, this means that the growth rate in each year can be represented by a probability distribution with an expected value of 10 per- cent, not that the growth rate is expected to be exacdy 10 percent in each future year. In this sense, the constant growth assumption is reasonable for many large, mature businesses.
Nonconstant Growth Stock Valuation Some firms exhibit constant dividend growth, or at least growth close enough to apply the constant growth model. However, many businesses do not. For example, some businesses that have not yet fully matured but have a solid dividend record may be growing much faster today than they will over the long term. At some point in time, as the business matures, the growth
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Chapter 7: Equity Financing 303
will fall to a steady rate. Also, some dividend-paying firms may temporarily suspend the dividends because of a temporary downturn, but they may have every intention of picking up the dividends when conditions improve. If a business is not expected to exhibit more or less constant growth in dividends in the future, the constant growth model cannot be used. To find the value of a nonconstant growth stock, assuming that the growth rate will eventually stabilize to some steady rate, we proceed as follows:
• Estimate the stock’s dividend stream on a year-by-year basis, stopping at the first dividend in the constant growth phase.
• Find the present value of the dividends during the period of nonconstant growth.
• Find the expected price of the stock at the end of the nonconstant growth period, at which point it has become a constant growth stock, and discount this price back to the present.
• Add the dividend and price components to find the value of the stock.
For an illustration of the process for valuing nonconstant growth stocks, suppose the following facts exist:
R(Rs) = Stockholders’ required rate of return = 16%.
N = Years of nonconstant growth = 3.
E(gn) = Rate of growth in dividends during the nonconstant growth period = 30%. (Note that the growth rate during the noncon- stant growth period could vary from year to year.)
E(gc) = Steady (constant) growth rate after the nonconstant period = 10%.
Do = last dividend paid = $1.82.
The valuation process, which is tedious but not difficult, is explained in the steps below:
1. Find the expected dividends during the nonconstant growth phase
(years 1, 2, and 3 in this case) plus the first dividend of the constant growth phase (Year 4) by multiplying each dividend by one plus the growth rate expected in the coming year:
D3 = D2 X 1.30 = $3,076 X 1.30 = $3,999.
D4 = D3 x 1.10 = $3,999 x 1.10 = $4,399.
2. Find the present values of the dividends that occur during the nonconstant growth phase, remembering that Do just occurred and thus does not contribute to the stock’s value:
PV Dj = $2,366 / (1.16)1 = $2,040.
PV D2 = $3,076 / (1.16)2 = $2,286.
PV D3 = $3,999 / (1.16)3 = $2,562.
3. The stock price expected at the end of Year 3 (the beginning of Year 4) can be found using the constant growth model because dividends are expected to grow at a constant rate of 10 percent in Year 4 and beyond. This price captures the value of all dividends beyond Year 3. Calculate the stock price at the end of Year 3 and then discount this value to Year 0:
D< R(RJ-E(g)
$4.399 0.16-0.10
= $73,317.
PV E(P3) = $73.32/(1.16/ = $46,971.
4. Add the present values to find the value of the stock today:
E(P0) = $2,040 + $2,286 + $2,562 + $46,971
= $53,859 « $53.86.
A B C D
1 2 30.0% E(g„) Nonconstant growth rate 3 10.0% E(g<) Constant growth rate 4 16.0% R(RS) Required rate of return 5 $1.82 Do Last dividend payment
6 7 $2,366 =A5*(1+A2) (entered into cell A7) 8 $3,076 =A7*(1 +A2) (entered into cell A8) 9 $3,999 =A8*(1 +A2) (entered into cell A9) 10 $4,398 =A9*(1+A3) (entered into cell A10) 11 $73,307 =A10/(A4-A3) (entered into cell Al 1) 12 | 13 $53.85 =NPV(A4,A7:A9)+PV(A4,3„-A 11) (entered into cell A13)
Here, we calculated the future dividend stream in cells A7 through A9 and the future stock price in cells A10 and All. (The dividend in cell A10 is needed only to calculate the future stock price in cell All.) Then, in cell Al 3, we calculated the present values of the three-year dividend stream and
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future stock price and added them together. (Note a small rounding differ- ence between the calculator and spreadsheet solutions.)
Although this illustration shows supernormal growth—in which the dividends are currently growing at a higher rate than the steady rate—the procedures illustrated here can be used with any pattern of nonconstant growth. This model can be used only in cases where the dividend stream returns to constant growth at some not-too-distant point in time.
Stock Valuation by the Free Cash Flow Method Earlier, we described three potential business situations that dictate the nature of the stock valuation process: start-up, earnings but no dividends, and dividend paying. In this section, we briefly describe the valuation process when earnings are more-or-less predictable but the corporation pays no divi- dends. This method is called the cash flow method, because it focuses on cash flows available for distribution to investors rather than dividends paid to stockholders.
Free cash flow is defined as Net income + Interest expense - Funds reinvested in the business. Thus, free cash flow represents the amount of money available to a business to pay its investors, including both equity investors (stockholders) and debt investors (debtholders). To conduct the valuation, future free cash flows are estimated and either the constant or non-constant growth model is used to find their present value, which repre- sents the total value of business. Note that the discount rate used to find the present value is the corporate cost of capital rather than the cost of equity, because the cash flows being discounted represent the aggregate risk to inves- tors, including both stockholders and debtholders.
To briefly illustrate the free cash flow method, assume that for-profit Tampa Physician’s Hospital (TPH) has a present value of free cash flows of $50 million. Because this value must be shared by stockholders and debt- holders, to focus on stock value it is necessary to first subtract the value that belongs to debtholders. Assuming that the market value of TPH’s debt is S10 million, $50 - $10 = $40 million is left as the total value of the corpora- tion’s common stock. Finally, if there are 5 million shares of common stock outstanding, the value of each share would be $40 / $5 = $8.
Valuation using free cash flow as the basis is used extensively when valu- ing businesses that do not have an established dividend track record. Thus, we revisit this approach in Chapter 16 (Business Combinations and Valuation).
1. What are three methods for valuing common stocks, and when does each apply?
SELF-TEST QUESTIONS
(continued)
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SELF-TEST QUESTIONS
(continued from previous page) 2. Write out and explain the dividend valuation model for a constant
growth stock in both the valuation and expected rate of return forms.
3. What are the assumptions of the constant growth model? 4. What are the key features of constant growth regarding dividend
yield and capital gains yield? 5. What are the key features of the nonconstant growth model? 6. Explain how to estimate stock value using the free cash flow
method.
Security Market Equilibrium
Investors will want to buy a security if its expected rate of return exceeds its required rate of return or, put another way, when its value exceeds its cur- rent price. Conversely, investors will want to sell a security when its required rate of return exceeds its expected rate of return (i.e., when its current price exceeds its value). When more investors want to buy a security than sell it, its price is bid up. When more investors want to sell a security than buy it, its price falls. In equilibrium^ these two conditions must hold:
1. The expected rate of return on a security must equal its required rate of return to the marginal investor. This means that no investor who owns the stock believes that its expected rate of return is less than its required rate of return, and no investor who does not own the stock believes that its expected rate of return is greater than its required rate of return. (The margined investor is the investor who is most likely to be the buyer or the seller on the next trade and hence has the greatest influence on stock prices.)
2. The market price of a security must equal its value to the marginal investor.
If these conditions do not hold, trading will occur until they do. Of course, security prices are not constant. A security’s price can swing wildly when new information becomes available that changes investors’ expectations concerning the security’s cash flow stream or risk, or when the general level of returns (i.e., interest rates) changes. However, evidence suggests that secu- rities prices—especially of securities that are actively traded, such as those issued by the US Treasury or by large firms—adjust rapidly to disequilibrium situations. Thus, most people believe that the bonds of the US Treasury and the bonds and stocks of major corporations are generally in equilibrium. The
j^ey to the rapid movement of security prices toward equilibrium is informa- tional efficiency, which is discussed in the next section.
1. What is meant by security market equilibrium? 2. What securities are most likely to be in equilibrium? 3. What is meant by the term marginal investor*
SELF-TEST QUESTIONS
Informational Efficiency
A securities market—say, the market for long-term US Treasury bonds—is informationally efficient if (1) all information relevant to the values of the securities traded can be obtained easily and at a low cost and (2) the market contains many buyers and sellers who act rationally in response to this infor- mation. If these conditions hold, current market prices will have embedded in them all information of possible relevance; hence, future price movements will be based solely on new information as it becomes known.
The efficient markets hypothesis (EMH)y which has three forms, formal- izes the theory of informational efficiency:
1. The weak form of the EMH holds that all information contained in past price movements is fully reflected in current market prices. Therefore, information about recent trends in a security’s price, or a bond’s yield, is of no value in choosing which securities will “outperform” other securities.
2. The semi-strong form of the EMH holds that current market prices reflect all publicly available information. Therefore, it makes no sense to spend hours and hours analyzing economic data and financial reports because whatever information you might find—good or bad— has already been absorbed by the market and embedded in current prices.
3. The strong form of the EMH holds that current market prices reflect all relevant information, whether publicly available or privately held. If this form holds, then even investors with “inside information,” such as corporate officers, would find it impossible to earn abnormal returns— returns in excess of that justified by the riskiness of the investment.
The EMH, in any of its three forms, is a hypothesis rather than a proven law, so it is not necessarily true. However, hundreds of empirical tests have been conducted to try to prove, or disprove, the EMH, and the results are relatively consistent. Most tests support the weak and semistrong forms of the EMH for well-developed markets, such as the US markets for
308 Understanding Healthcare Finance Management
large firms’ stocks and bond issues and for Treasury securities. SuppOrte of these forms of the EMH note that there are 100,000 or so full-tini highly trained, professional analysts and traders operating in these market Furthermore, many of these analysts and traders work for businesses such Citibank, Fidelity Investments, Merrill Lynch, Prudential, and the like that have billions of dollars available to take advantage of undervalued securities Finally, as a result of disclosure requirements and electronic informatio networks, new information about these heavily followed securities is almost instantaneously available. Therefore, security prices in these markets adjust almost immediately as new developments occur, and hence prices reflect all publicly available information.
Virtually no one, however, believes that the strong form of the EMH holds. Studies of legal purchases and sales by people with inside information indicate that insiders can make abnormal profits by trading on that infor- mation. It is even more apparent that insiders can make abnormal profits if they trade illegally on specific information that has not been disclosed to the public, such as a takeover bid, a research and development breakthrough, and the like.
The EMH has important implications both for individual investment decisions and for business financing decisions. Because security prices appear to generally reflect all public information, most actively followed and traded securities are in equilibrium and fairly valued. Being in equilibrium, however, does not mean that new information cannot cause a security’s price to soar or to plummet, but it does mean that most securities are neither underval- ued nor overvalued. Therefore, over the long run, an investor with no inside information can expect to earn only a return on a security that compensates her for the amount of risk assumed. In the short run—for example, a year— an investor can expect to earn only a return that is the same as the average for securities of equal risk. In other words, investors should not expect to “beat the market” after adjusting for risk. Also, because the EMH applies to the major bond markets, bond prices and hence interest rates reflect all current public information. Future interest rates are impossible to forecast consistently because interest rates change in response to new information.
For managers, the EMH indicates that managerial decisions generally should not be based on perceptions about the market’s ability to properly price the firm’s securities or on perceptions about which way interest rates will move. In other words, managers generally should not try to time new stock issues to catch high prices or new bond issues to catch low interest rates. However, in some situations, managers may have information about their own firms that is unknown to the public. This condition is called asymmetric information, which can affect managerial decisions. For example, suppose a drug manufacturer has made a breakthrough in Alzheimer research but wants
Chapter 7: Equity Financing 309
niaintain as much secrecy as possible jbout the new drug. During final develop- ment and testing, the firm might want to jgjay any new securities offerings because securities can probably be sold under more favorable terms once the announcement j$ made. Managers can, and should, act on inside information for the benefit of [heir firms, but inside information cannot legally be used for personal profit.
Are markets really efficient? If mar- kets were not efficient, the better manag- ers of stock and bond mutual funds and pension plans would be able to consis- tently outperform the broad averages over long periods. In fact, few managers can consistently better the broad averages, and during most years, mutual fund managers, on average, underperform the market. In any year, some mutual fund managers will outperform the market and others will underperform the market—this is known
with certainty; but for an investor to beat the market by investing in mutual funds, she must identify the successful managers beforehand, which seems difficult, if not impossible, to do.
Despite evidence to the contrary, many theorists, and even more Wall Street experts, believe that pockets of inefficiency do exist. In some cases, entire markets may be inefficient. For example, the markets for the securities issued by small firms may be inefficient because there is either an insufficient number of analysts ferreting out information on these companies or an insufficient number of investors trading these securities. Many people also believe that individual securities traded in efficient markets are occasionally priced inefficiendy, or that investor emotions can drive prices too high during raging bull markets (such as the one seen in the 1990s) or too low during whimpering bear mar- kets (such as the one that started in 2008). Indeed, if investors are driven more by greed and emotion than by rational assessments of security values, markets may not really be as efficient as claimed by supporters of the EMH.
Behavioral Finance Behavioral finance is a field of study that pro- poses psychology-based theories to explain stock market anomalies. Proponents argue that investors are not nearly as rational as traditional finance theory makes them out to be. Of course, the idea that psychology drives stock market movements flies in the face of the efficient mar- kets hypothesis. In fact, behaviorists (as they are called) contend that, rather than being unusual, irrational behavior is commonplace. Here is one of the experiments they cite to support that view.
Suppose you are given a choice of a sure $50 or coin flip in which you could win either $100 or nothing. Most people would pocket the sure $50. Now, suppose you are confronted with this choice: a sure loss of $50 or a coin flip in which you could lose either $100 or nothing. Now, most people would choose the coin toss, although the value inherent in flipping the coin is equivalent in both scenarios. The idea here is that people tend to view the possibility of recouping a loss as more important than the possibility of greater gain.
The priority of avoiding losses also affects investor behavior. It is common for investors to watch a particular stock plummet in value but refuse to sell because it would “lock in” the loss coupled with the belief that the price will eventually bounce back to the value it had once achieved. Although behavioral finance offers no investment miracles, perhaps it can help inves- tors train themselves to watch their own behavior and, in turn, avoid mistakes that would be detri- mental to their personal wealth.
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Benjamin Graham, a well-respected stock market pundit, des- the EMH as a theory that “could have great practical importance if it • • cided with reality.” Graham proposed that the price of every stock const of two components: investment value and a speculative element. Investm© value measures the worth of all the cash flows a company will generate in th • future, while the speculative element is driven by sentiment and emotions such as hope, greed, fear, and regret. The market is highly efficient at iden' tifying investment value. However, the speculative element is prone to lar and rapid swings that can, at times, swamp investment value.
Whether the market is truly efficient, partially efficient, or totally inef ficient seems to have little bearing on how easy it is to beat. We know this because the so-called investment experts would have much better results than they do as evidenced by the fact that only 3 percent of actively managed mutual funds deliver results that exceed those merely due to chance.4
In closing our discussion of market efficiency, let’s talk a little bit about what it means to “beat the market.” First, consider the short run—say, one year. You may hold a portfolio of stocks that realizes a 20 percent return in a given year. Is that a good return? Yes. Over the past 80 or so years, a diversified investment in stocks averaged an annual return of roughly 10 percent. However, the 20 percent return in any given year does not mean that you beat the market in that year. To actually beat the market, you must realize a return that is higher than the average return on similar portfolios of stocks (portfolios that have the same risk as yours). If the average return (benchmark) on a similar-risk portfolio for that year was 25 percent, some portfolios did better than average and others did worse, including yours. If market efficiency holds, however, those that did better in one year will not be able to consistently beat the relevant benchmark year after year.
What about the long run? Over the long run—say, ten or more years— beating the market means a return in excess of that commensurate with die riskiness undertaken. For stocks, this means an average annual return of roughly 10 percent (based on historical performance).
We really do not know whether it is possible to beat the market by skill or whether it is just a matter of luck. Nevertheless, it is wise for both investors and managers to consider the implications of market efficiency when making investment and financing decisions. Investors who believe that they can beat the market should at least recognize that there is a lot of evidence that tells us that most people who try to do so will ultimately fail.
SELF-TEST QUESTIONS 1. What two conditions must hold for markets to be efficient?
2. Briefly, what is the EMH? 3. What are the implications of the EMH for investors and managers? 4. What is meant by the phrase “beat the market”?
Chapter 7: Equity Financing
The Risk/Return Trade-Off
Most financial decisions involve alternative courses of action. For example, should a hospital invest its excess funds in Treasury bonds that yield 4 percent or in Tenet bonds that yield 6 percent? Should a group practice buy a replace- ment piece of equipment now or wait until next year? Should a joint venture outpatient diagnostic center purchase a small, limited-use MRI (magnetic res- onance imaging) system or a large, and more expensive, multipurpose system?
Generally, alternative courses of action have different expected rates of return, and one may be tempted to automatically accept the alternative with the higher expected return. However, this approach to financial deci- sion making would be incorrect. In efficient markets, alternatives that offer higher returns also entail higher risk. The correct question to ask when mak- ing financial decisions is not which alternative has the higher expected rate of return but which alternative has the higher return after adjusting for risk. In other words, which alternative has the higher return over and above the return commensurate with that alternative’s riskiness?
For an illustration of the risk/return trade-off suppose Tenet stock has an expected rate of return of 12 percent, while its bonds yield (and have an expected rate of return of) 6 percent. Does this mean that investors should flock to buy the firm’s stock and ignore the bonds? No. The higher expected rate of return on the stock merely reflects that the stock is riskier than the bonds. Investors who are not willing to assume much risk will buy Tenet’s bonds, while those that are less risk averse will buy the stock. From the perspective of Tenet’s managers, financing with stock is less risky than financing with debt, so the firm is willing to pay the higher cost of equity to limit the firm’s risk exposure.
Despite the hypothesized efficiency of major securities markets, the mar- kets for products and services (i.e., the markets for real assets, such as MRI systems, and services, such as inpatient healthcare) are usually not efficient; hence, returns are not necessarily related to risk. Thus, hospitals, group prac- tices, and other healthcare businesses can make real-asset investments and achieve returns in excess of those required to compensate for the riskiness of the investment. Furthermore, the market for innovation (i.e., the market for ideas) is not efficient. Thus, it is possible for people like Mark Zuckerberg, one of the founders of Facebook, to become multibillionaires at a relatively young age. However, when excess returns are found in the product, service, or idea mar- kets, new entrants quickly join the innovators, and competition over time usu- ally forces rates of return down to efficient market levels. The result is that later entrants can expect only returns that are commensurate with the risks involved.
1. Explain the meaning of the term risk/return trade-off. 2. In what markets does this trade-off hold?
SELF-TEST QUESTIONS
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Chapter Key Concepts This chapter contains a wealth of material on equity financing and how securities are brought to market. Here are its key concepts:
• The most important common stockholder rights are a claim on the firm’s residual earnings, control, and the preemptive right.
• New common stock may be sold by for-profit corporations in six ways: (1) on a pro rata basis to existing stockholders through a rights offering-, (2) through investment bankers to the general public in a public offering-, (3) to a single buyer, or a small number of buyers, in a private placement-, (4) to employees through an employee stock purchase plan-, (5) to shareholders through a dividend reinvestment plan-, and (6) to individual investors by direct purchase.
• A closely held corporation is one that is owned by a few individuals who typically are the firm’s managers.
• A publicly owned corporation is one that is owned by a relatively large number of individuals who are not actively involved in its management.
• Not-for-profit firms do not have access to the equity markets. However, charitable contributions, which are tax deductible to the donor, and governmental grants constitute unique equity sources for not-for-profit firms.
• Under the dividend valuation model, the value of a share of stock is found by discounting the stream of expected dividends by the stock’s required rate of return.
• The value of a stock whose dividends are expected to grow at a constant rate for many years is found by applying the constant growth model:
p/p' Dox[l + E(g)] = E(D,) 1 R(RS)-E(g) R(RS)-E(g)’
The expected rate of return on a stock consists of an expected dividend yield plus an expected capital gains yield. For a constant growth stock, both the expected dividend yield and the expected capital gains yield are constant over time, and the expected rate of return can be found using this equation:
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• The efficient markets hypothesis (EMH) holds that (1) stocks are always in equilibrium and fairly valued, (2) it is impossible for an investor to consistently beat the market, and (3) managers should not try to forecast future interest rates or time security issues.
• In efficient markets, alternatives that offer higher returns must also have higher risk; this condition is called the visk/return trade-off. The implication is that investments must be evaluated on the basis of both risk and return.
This concludes our discussion of the features and valuation of equity financing. In Chapter 8, we discuss lease financing, which is an alternative to debt and equity financing.
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
• A chapter model that shows how to perform many of the calculations described in the chapter
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and tests your
ability to perform the calculations in preparation for a case
These resources can be accessed on the book’s companion website at ache.org/books/UHFM7.
Selected Case
The following case in Cases in Healthcare Finance, 5th edition, focuses on the mechanics of equity valuation:
• Case 15: Pacific Healthcare (B).
Selected Bibliography
Becker, S., and R. Lundeen. 2007. “Fairness Opinions in Health Care Transactions—
Cause and Effect: The Emergence of Private Equity Funds as a Driving Force
314 Understanding Healthcare Finance Management
css in Big and Small Transactions and the Resulting Increased Use of Fajr Opinions.” Journal of Health Care Finance 33 (3): 85-91.
Brau, J. C., and D. B. Heywood. 2008. “IPO and SEO Waves in Health Care 1{. j Estate Investment Trusts.” Journal of Health Care Finance 35 (1); 70-^9
Brau, J. C., and J. M. Holloway. 2009. “An Empirical Analysis of Health Care IPOs and SEOs.” Journal of Health Care Finance 35 (4): 42-64.
Cleverley, W. O., and J. O. Cleverley. 2005. “Philanthropy: The Last Frontier f0 Capital Funding.” Journal of Healthcare Management 50 (5): 290-93. Jarvis, W. F. 2011. “Endowment Income for the Post-Reform Era.” Healthcare Financial Management 65 (5): 132. Robbins, C. J., T. Rudsenske, and J. S. Vaughan. 2008. “Private Equity Investment
in Health Care Services.” Health Affairs 27 (5): 1389-98. Williams, D., W. J. Duncan, P. M. Ginter, and R. M. Skewchuk. 2006. “Do Gov-
ernance, Equity Characteristics, and Venture Capital Involvement Affect Long-Term Wealth Creation in U.S. Health Care and Biotechnology IPOs?" Journal of Health Care Finance (September 22): 54-71.
Selected Websites
The following websites pertain to this chapter:
• To learn more about stock exchanges, see the NYSE site at www.nyse. com. You can research listing requirements as well as learn how the NYSE works. Also, see the NASDAQ site at www.nasdaq.com.
• To learn about ESOPs, see the website of the Employee Stock Ownership Association at www.esopassociation.org.
• To learn more about DRIPs, see the DRIP investor site at www. dripinvestor, com.
Notes
1. In the typical voting procedure, a stockholder who owns 1,000 shares can cast 1,000 votes for each director whose seat is contested. An alternative voting procedure, called cumulative voting, is used at some corporations. Here, the 1,000-share stockholder would get 3,000 votes if three seats were being contested, and he can cast all of them for one director. Cumulative voting helps small groups of shareholders gain a voice on the board.
2. Venture capitalists are individuals and firms that supply capital to small, start-up businesses that do not have the track record necessary to
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obtain capital from banks or public markets. This type of financing is referred to as first-round financing. The capital may be in the form of debt or equity, but debt investments usually are accompanied by stock options or some other “equity kicker” that gives the venture capitalist an ownership position in the business. Although many venture capital investments never pan out, those that do typically create huge returns when the venture capitalists “cash out” after the successful firm has gone public.
3. If a stock is held for more than one year, any profit is classified as a long-term capital gain and hence taxed at a lower rate than is ordinary income. Furthermore, taxes are not paid until the stock is sold, so there is a time value of money benefit.
4. See Fama, E. F., and K. R. French. 2009. “Luck Versus Skill in the Cross Section of Mutual Fund Returns.” Social Science Research Network http://papers.ssrn.com/sol3/papers.cfnVabstract_idM356021.
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Integrative Application
The Problem
Sally Randolph is a surgical nurse at Wellford Surgery Centers (WSC), a small for- profit ambulatory surgery center owner/operator whose stock is thinly traded in the OTC market. A few nights ago, Sally received a call from her mother asking for some advice regarding a stock recommendation. Her mother said that her broker had recommended adding 1,000 shares of WSC stock to the family’s retirement portfolio. Because Sally worked at WSC, her mother thought that Sally might have some special insights. Also, Sally’s mother just read a short article in an investment magazine regarding market efficiency and behavioral finance, and she asked what impact these ideas have on the broker’s recommendation.
Sally was finishing up her healthcare MBA at a local university, so she thought this would be a good opportunity to apply some of the stock valuation concepts she had learned. To begin, she looked up some basic data:
WSC beta coefficient = 1.2.
Yield on treasury bonds = 7.0%.
Market risk premium = 5.0 percentage points.
Last dividend paid = $2.00.
Expected growth rate = a constant 6.0%, or alternatively
= 10.0% for 3 years and 5.0% constant growth thereafter.
Current stock price = $33.00.
Now, she must use this information to make some judgments about whether or not her mother should follow the broker’s advice.
The Analysis
First, use the Security Market Line (SML) of the capital asset pricing model (CAPM) to estimate the required rate of return on the stock:
R(RWSC) = RF + (RIRJ ~ RF) x bwsc = RF + (RPM x
bwsc)
= 7.0% + (5.0% x 1.2) = 13.0%.
Next, estimate the current value of the stock using the constant growth valuation model:
Chapter 7: Equity Financing 317
Alternatively, use the expected rate of return version of the model:
Finally, use the nonconstant growth model to estimate WSC’s current
E(RWSC) = [Do x [1 + E(g)J] / Po + E(g) = E(Dp / Po + E(g)
= $2.12 / $33.00 + 6.0% = 6.4% + 6.0% = 12.4%.
E(Pwsc) = Dox[i + E(g)]/[R(Rs)-E(g)] = $2.00 x 1.06 / [0.13 - 0.06] = $2.12 / 0.07 = $30.29.
Do = $2.00. = Do x 1.10 = $2,000 x 1.10 = $2,200.
D2 = Ds x 1.10 = $2,200 x 1.10 = $2,420. D3 = Dz x 1.10 = $2,420 x 1.10 = $2,662. D4 = D3 x 1.05 = $2,662 x 1.05 = $2,795.
E(Pp = D41 [R(Rs) - E(g)] = $2,795 / [0.13 - 0.05] = $2,795 I 0.08 = $34- 938. PV Dt = $2,200 I (1.13)1 = $1,947. PV D2 = $2,420 I (1.13)2 = $1,895. PV D3 = $2,662 I (1.13)3 = $1,845.
PV E(P3) = $34-938 I (1.13)3 = $24,214. E(P°) = $1,947 + $1-895 + $1,845 + $24-214 = $29,901 ~ $29.90.
The Decision
Sally estimated the current value of WSC’s stock to be $30.29 using the con- stant growth dividend model and $29.90 using the nonconstant growth model. Considering all the uncertainties involved in the valuation processes, $30 seems a reasonable final estimate. However, the current stock price is $33, so it appears that the stock is overvalued by the market and hence should not be bought. (Alternatively, the constant growth expected rate of return on the stock is 12.4 percent, while Sally’s required rate of return is 13.0 percent. Because the expected return is less than that required, the stock should not be purchased.)
However, these judgments require that (1) the valuation estimates are cor- rect and (2) the market for WSC’s stock is efficient. If the market is not efficient (perhaps because the stock is infrequently traded), the current price may not reflect all public information and new information may cause the price to soar as opposed to fall to Sally’s value estimate. Sally, wisely, declined to offer an opinion regarding the stock recommendation. However, she did suggest that her mother think about buying a low-cost, well-diversified mutual fund for her retire- ment portfolio rather than invest in individual stocks. ■
CHAPTER SUPPLEMENT
7 CLASSIFIED STOCK, PREFERRED STOCK, SECURITIES REGULATION, AND THE INVESTMENT BANKING PROCESS
Supplement Learning Objectives After studying this chapter supplement, readers should be able to
• explain the purpose of classified stock, • discuss the features of preferred stock and how it is valued, • describe the key components of securities regulation, and • explain the investment banking process.
Classified Stock
Corporations, especially start-up businesses, sometimes use classified stock to meet special needs. Generally, when special classifications of stock are used, one type is designated Class A, another Class B, and so on. Small, new firms seeking to obtain funds from outside sources frequently use different types of common stock. For example, when Genetic Research, Inc., went public in 2013, its Class A stock was sold to the public and paid out a token dividend, but it carried no voting rights for five years. Its Class B stock was retained by the founders of the corporation and carried full voting rights for five years, but dividends could not be paid on the Class B stock until the business had established its earning power by building up retained earnings to a designated level. The corporation’s use of classified stock allowed the public to take a position in a conservatively financed growth business and to earn a small amount of dividend income, while the founders retained absolute control during the crucial early stages of the business’s development. At the same time, outside investors were protected against excessive withdrawals of funds by the original owners. As is often the case in such situations, the Class B stock was also called founders’ shares.
Note that “Class A,” “Class B,” and so on have no standard mean- ings. Most corporations have no classified shares, but a business that does can designate its Class B shares as founders’ shares and its Class A shares as those sold to the public, while another firm can reverse these designations. Other firms can use the A and B designations for entirely different purposes.
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Chapter 7 Supplement: Classified Stock . . . 319
In general, voting rights are one of the distinguishing features of clas- sified stock. For example, suppose that Big East Healthcare had two classes ()f stock that differed only with respect to voting rights: Class V had such rights, while Class N did not. As you would expect, the Class V stock would be more valuable than the Class N stock, typically by about 2 percent to 5 percent. Thus, if the Class N stock were selling at $100 per share, the Class V stock might sell for $104.
1. Name several types of classified stock and explain their uses. 2. How would the values of voting and non voting stock differ?
SELF-TEST QUESTIONS
Preferred Stock
Preferred stock, which is sometimes used by investor-owned firms, is a hybrid: It is similar to debt in some respects and to common stock in other ways. Accountants classify preferred stock as equity, so it is shown on the balance sheet as an equity account. However, from a financial management perspec- tive, preferred stock is closer in nature to debt than to equity. Preferred stock imposes a fixed charge on the firm, and hence it has a similar impact on the riskiness of the business as does debt financing.
Basic Features Preferred stock usually has a stated par, or face, value—often $100. The divi- dend on preferred stock, which is the equivalent of interest on a debt security, typically is paid quarterly. When a preferred issue is sold, the dividend is stated either as some percentage of par value or as so many dollars per share. For example, in 2012, Regent Healthcare, a for-profit integrated healthcare system, sold 500,000 shares of $100 par value preferred stock, raising a total of $50 million in new capital. This issue had a stated dividend of 5 percent, so the annual dollar dividend was $5, or $1.25 each quarter. Preferred dividends are generally fixed at issue, so Regent’s preferred dividend will remain at $5 per year regardless of interest rate changes over time. Thus, if the required rate of return on Regent’s preferred dividend increases to 7 percent, the value of the stock will fall, just as the value of a debt security falls when interest rates rise.
Although preferred stock contains a promise to pay the stated divi- dend, issuers do not have a contractual obligation to make the payment, dhus, like common stock, preferred stock dividends are declared each quarter hy the business’s board of directors; if the issuer’s financial condition dete- n°rates, the board can elect to omit, or pass, the dividend. However, most Preferred issues are cumulative, which means that the cumulative total of all Unpaid preferred dividends (called arrearages) must be paid before common stOck dividends can be paid.
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Preferred stock typically carries no voting privileges, so preferre j stockholders have no ownership rights. However, most preferred iSsuJ stipulate that preferred stockholders can elect a minority of directors say 3 out of 12—if the preferred dividends are passed. Even though nonpayment of preferred dividends will not bankrupt a corporation, businesses issue prc ferred stock with every intention of paying the promised dividends. Passing a dividend usually precludes the payment of common dividends and places preferred stockholders on the board. Furthermore, businesses with preferred dividends in arrears have a difficult time selling new debt and find it almost impossible to sell new common or preferred stock.
Investors regard preferred stock as riskier than debt for two reasons- (1) preferred dividends will be omitted before interest payments because default on interest payments has more serious consequences, and (2) jn the event of bankruptcy and liquidation, preferred stockholders’ claims are junior (subordinate) to debtholders’ claims. Accordingly, investors require a higher rate of return on a corporation’s preferred stock than on its bonds. However, preferred stock has tax advantages to corporate buyers because 70 percent of the preferred dividends received by a corporation are exempt from corporate taxes. Thus, a corporate buyer of Regent’s preferred stock in the 40 percent tax bracket would pay 40 percent taxes on 30 percent of the preferred dividend for an effective tax rate of only 0.40 x 0.30 = 0.12 = 12%. If the corporate buyer purchased Regent’s debt, it would have to pay taxes on the interest earned at the full 40 percent rate. In addition, under current tax law (which is subject to frequent changes), preferred dividends received by individuals, like common dividends, are taxed at a lower rate than interest or ordinary earnings. Because of these tax advantages to buyers, dividend rates on preferred stock are pushed down to the point where before-tax returns typically are lower on preferred stock than on lower-risk bonds.
Almost half of all preferred stock sold in recent years is convertible, which means that it can be converted into, or exchanged for, a set number of shares of common stock. The number of common shares obtained by conversion is set low enough when the convertible is issued so that immedi- ate conversion makes no financial sense. Over time, however, if the price on the firm’s common stock rises, a point is reached when the holders of the preferred stock will be better off if they convert the preferred into common.
Some older preferred stocks are similar to perpetual bonds in that they have no maturity date. However, all preferred stock issued today has either a sinking fund or call provisions that limit the life of the issue. For example, many preferred shares have a sinking fund that calls for the retirement of 2 percent of the issue each year, which means that the average maturity of the issue is 25 years and that the issue will be totally refunded in 50 years.
Chapter 7 Supplement: Classified Stock . . .
Advantages and Disadvantages of Preferred Stock Financing \ lot more can be said about preferred stock, particularly about the type that
is convertible into common stock. However, this type of equity is not a major source of funding for healthcare businesses, so we will conclude our discus- sion with the advantages and disadvantages of “regular” preferred stock, from the viewpoint of the issuer, there are three primary advantages:
1. Unlike debt financing, the obligation to pay preferred dividends is not contractual, so a business can pass (omit) a preferred dividend and not be forced into bankruptcy.
2. By issuing preferred stock rather than common stock, the corporation does not dilute the market value of the common stock and the stockholders’ share of control.
3. Because preferred stock often has a longer maturity than debt, preferred stock pushes principal repayments further into the future than debt issues typically do.
There are two major disadvantages:
1. Preferred stock dividends are not deductible from taxable income by the issuer, so the after-tax cost on a preferred issue typically is higher than the cost of a similar debt issue. However, the fact that preferred stock has tax advantages to buyers means that the difference in cost is not as great as it first appears.
2. Although preferred dividends can be passed, investors expect them to be paid. If they are not, there are negative consequences for the issuer, so preferred dividends impose a more stringent fixed cost on a business than do common dividends. Thus, like the use of debt financing, the use of preferred stock increases the financial risk of a business and hence its cost of common stock.
Preferred Stock Valuation Most preferred stocks entitle their owners to regular, fixed dividend pay- ments. If the stock is perpetual preferred—payments are expected to last for- ever—the stock can be valued using the following simple formula:
On the web at: ache.org/books/ UHFM7
Key Equation S7.1: Preferred Stock Model (Valuation)
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Here, E(Pp) is the value (expected price) of the preferred stock 0 is the preferred dividend, and R(Rp) is the required rate of return on tl/ preferred stock. For example, assume that Medical Associates Corporation’ (MAC) perpetual preferred dividend is $10 per year. If interest rates rose since the stock was issued, and the required rate of return is now 12 percent the value of the stock would be $83.33:
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= $83.33.
The required rate of return on the issue would be determined in the same manner as for debt, as we discuss in Chapter 6.
Preferred dividends typically are paid quarterly, so the holder of MAC’s preferred stock actually receives a quarterly dividend of $10/4 = $2.50. The value of the preferred stock can be calculated on the basis of this quarterly dividend if we recognize that the quarterly required rate of return would be 12%/4 = 3%:
$2.50 0.03
= $83.33.
In theory, investors would now look at the current stock price. If it is greater than $83.33, the preferred stock should not be purchased, and if it is less than $83.33, the stock is attractive.
Although calculating the value of a preferred stock is a reasonable approach to making the investment decision, most investors make preferred stock investment decisions on the basis of expected rate of return. This approach is similar to that used by debt investors, who make decisions on the basis of yield to maturity. The expected rate of return on preferred stock, E(Rp), can be determined easily by rearranging the valuation equation:
Key Equation S7.2: Preferred Stock Model (Rate of Return)
D E(Rp) =
xp
For example, the expected rate of return on MAC’s preferred stock, if it is currently selling for $85, is 11.8 percent:
Chapter 7 Supplement: Classified Stock . . . 323
If we use the quarterly dividend of $2.50 and a price of $85 as inputs into the equation, we get a quarterly expected rate of return of 2.94 percent. This expected rate of return is then multiplied by four to arrive at a stated (annual) rate of 11.8 percent. (Alternatively, the effective annual rate, which includes the effect of quarterly compounding, is 12.3 percent.) If an investor has a required rate of return on the stock of less than 11.8, he should pur- chase it. Conversely, if his required rate of return is greater than 11.8 percent, he should not buy the stock.
Although there are some perpetual preferred issues that remain out- standing forever (perpetuities), virtually all preferred stock issued today has either a sinking fund or a call provision that limits the stock’s maturity. When the maturity is limited, preferred stock is valued using the debt valuation techniques described in Chapter 6.
1. What are the general features of preferred stock? 2. Should preferred stock be considered equity or debt financing?
Explain your answer. 3. What are the advantages and disadvantages of preferred stock
financing? 4. How are perpetual preferred stocks valued? What about
nonperpetual preferred?
SELF-TEST QUESTIONS
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Securities Regulation
Sales of new securities and sales in the secondary markets are regulated by the Securities and Exchange Commission (SEC) and, to a lesser extent, by each of the 50 states. Here are the primary elements of SEC regulation:
• The SEC has jurisdiction over all interstate offerings of new securities to the public in amounts of $1.5 million or more.
• Newly issued securities must be registered with the SEC at least 20 days before they are publicly offered. The registration statement provides financial, legal, and technical information about the firm to the SEC, and the prospectus summarizes this information for investors. SEC lawyers and accountants analyze the registration statement and the prospectus; if the information is inadequate or misleading, the SEC will delay or stop the public offering.
• After the registration has become effective, new securities may be offered, but any sales solicitation must be accompanied by the prospectus. Preliminary, or red herring, prospectuses may be distributed
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to potential buyers during the 20-day waiting period, but no sales may be finalized during this time. A red herring prospectus contains all the key information that will appear in the final prospectus except the price, which is generally set after the market closes the day before the new securities are “officially” sold to the public.
• If the registration statement or prospectus contains misrepresentations or omissions of material facts, any purchaser who suffers a loss may sue for damages. Severe penalties may be imposed on the issuer or its officers, directors, accountants, engineers, appraisers, underwriters, and all others who participated in the preparation of the registration statement or prospectus.
• The SEC also regulates all national stock exchanges. Firms whose securities are fisted on an exchange must file annual reports similar to the registration statement with both the SEC and the exchange.
• The SEC has control over corporate insiders. Officers, directors, and major stockholders must file monthly reports of changes in their holdings of the stock of their corporation.
• The SEC has the power to prohibit manipulation by such devices as pools (large amounts of money used to buy or sell stocks to artificially affect prices) or wash sales (sales made among members of the same group to record artificial transaction prices).
• The SEC has control over the form of the proxy statement and the way the firm uses it to solicit votes.
Control over the use of credit to buy securities (primarily common stock) is exercised by the Federal Reserve Board through margin require- ments, which specify the maximum percentage of the purchase price that can be financed by brokerage borrowings. The current margin requirement is 50 percent, so stock investors can borrow up to half of the cost of a stock pur- chase from their broker. (Of course, the entire amount on account with the broker could be borrowed from another source, so margin requirements con- trol only broker-supplied debt capital.) If the stock price of a stock bought on margin falls, and the margin money (up to 50 percent of the original value) becomes more than half the current value, the investor is forced to put up additional personal funds. Such a demand for more personal money is known as a margin call. The amount of additional funds required depends on the maintenance margin, which is set by the broker supplying the loan. When a large proportion of trades are on margin and the stock market begins a retreat, the volume of margin calls can be substantial. Because most investors who buy on margin do not have a large reserve of personal funds, they are forced to sell some stock to meet margin calls, which, in turn, can accelerate the market decline.
Chapter 7 Supplement: Classified Stock . . . 325
States also have some control over the issuance of new securities within their boundaries. This control is usually exercised by a corporation commis- sioner or someone with a similar title. State laws relating to security sales are called blue sky laws because they were put into effect to keep unscrupulous promoters from selling securities that offered the “blue sky” but that actually had little or no assets or cash flows behind them.
The securities industry realizes the importance of stable markets, sound brokerage firms, and the absence of price manipulation. Therefore, the Financial Industry Regulatory Authority (FINRA) was established in 2007 by the consolidation of existing regulatory groups as the primary inde- pendent regulator for all securities firms doing business in the United States. FINRA’S mission is to protect investors by ensuring that the securities indus- try operates fairly and honestly. It oversees the work of about 4,250 broker- age firms and approximately 629,525 registered securities representatives as well the OTC market and stock exchanges. FINRA has approximately 3,400 employees in its two primary offices in Washington, DC, and New York City and 20 regional offices around the country.
In general, government regulation of securities trading—as well as industry self-regulation—is designed to ensure (1) that investors receive information that is as accurate as possible, (2) that no one artificially manipu- lates the market price of a given security, and (3) that corporate insiders do not take advantage of their position to profit from their firms’ securities at the expense of others. Neither the SEC, the state regulators, nor FINRA can prevent investors from making foolish decisions or from having bad luck, but they can—and do—help investors obtain the best data possible for making sound investment decisions.
1. What are the key features of securities markets regulation?
The Investment Banking Process
In this section, we discuss the procedures used by businesses to issue new securities—that is, the investment banking process. To begin, note that the new issue process takes place in two stages.
Stage I Decisions In Stage I, the business makes some preliminary decisions, including the following:
• Dollars to be raised. How much new capital is needed?
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• Type of securities to be used. Should common stock, bonds, some other security, or a combination of securities be used? Furthermore if common stock is to be issued, should it be done as a rights offering X a direct sale to the general public, or by a private placement? If the sale will be by a public offering, the next two decisions must be made.
• Competitive bid versus negotiated deal. Should the business simply offer a block of securities for sale to the highest bidding investment banker, or should it negotiate a deal with a single investment banker? These two procedures are called competitive bids and negotiated deals respectively. Only about 100 of the largest firms, whose securities are already well known to the investment banking community, are in a position to use the competitive bidding process. The investment banks must do a large amount of investigative work to bid on an issue, so such costs would be too high to make bidding worthwhile unless the potential fees generated were large. Thus, most businesses generally offer stocks or bonds on a negotiated basis.
• Selection of an investment banker. Most deals are negotiated, so the firm must select an investment banker. This choice can be an important decision for a firm that is going public. On the other hand, an older firm that has already “been to market” will have an established relationship with an investment banker. However, it is easy to change bankers if the firm is dissatisfied. Different investment banking houses are better suited for different firms. The older, larger establishment houses, such as J.P. Morgan, deal mainly with large, established firms. Other investment banking houses specialize in smaller firms or new issues, technology firms, or some other niche of the equity markets. To get some idea of the major players in the investment banking business, see Exhibit S7.1, which lists the top five corporate debt underwriters for 2012.
Stage II Decisions Stage II decisions, which are made jointly by the issuing business and its selected investment banker, include the following:
EXHIBIT S7.1 Top Five Debt Dollar Amount of Securities Market Share
UnderwritersUnderwriter Managed (in billions of dollars) %
for 2012J.P. Morgan 244-5 7-2 Citigroup 199.5 5-8 Bank of America 188.3 5-5 Deutsche Bank 176.5 5-2 Barclays 157-4 4-6
Source: Marketrealist.com (2013).
Chapter 7 Supplement: Classified Stock . . .
• Reevaluation of initial decisions. The issuer and its banker will reevaluate the initial decisions regarding the size of the issue and the type of securities to be used. For example, the business may have decided initially to raise $100 million by selling common stock, but the investment banker may convince management that, under current market conditions, the firm would be better off limiting the stock issue to $50 million and raising the other $50 million as debt.
• Contractual basis of sale. The firm and its investment banker must decide whether the banker will work on a best-efforts basis or will underwrite the issue. In a best-efforts sale, the banker does not guarantee that the securities will be sold or that the firm will get the cash it needs; it guarantees only that it will put forth its best efforts to sell the issue. On an underwritten issue, the firm does get a guarantee because the banker agrees to buy the entire issue and then resell the stock to its customers. Bankers bear significant risk in underwritten offerings because if the price of the security falls between the time the security is purchased from the issuer and the time of resale to the public, the investment banker must bear the loss.
• Banker’s compensation and other expenses. The investment banker’s compensation must be negotiated. Also, the issuer must estimate the other issuance expenses it will incur, such as lawyers’ fees, accountants’ costs, and printing and engraving expenses. In an underwritten issue, the banker will buy the issue from the firm at a discount from the price at which the securities are to be offered to the public; this “spread” is set to cover the banker’s costs and to provide a profit. In a best-efforts sale, fees to the investment banker are normally set as some percentage of the dollar volume sold.
• Offering price. If the business is already publicly owned, the offering price will be based on the existing market price of its stock or the yield on its bonds. On underwritten issues, the investment banker buys the securities at a prescribed discount from the closing price on the last day of registration. Usually, such agreements have escape clauses that provide for the contract to be voided if the price of the security drops below some preset amount. The purpose of such clauses is to allow the issuing firm to withdraw the issue if the price sinks to a point that the needed amount of money would not be raised.
The investment banker will have an easier job if the issue is priced relatively low, but the issuer of the securities naturally wants as high a price as possible. Some conflict of interest on price, therefore, arises between the investment banker and the issuer. If the issuer is financially sophisticated and makes comparisons with similar security issues, the investment banker will be forced to price close to the market.
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If the firm is going public, there is no established price for the hence, the investment banker will have to estimate the equilibrium price”^ which the stock will sell after it is issued. If the offering price is set below th • true equilibrium price, as with most initial public offerings (IPOs), the sto price will rise sharply on the first day of trading. For example, HealtheoJ IPO was priced at $8, but the stock closed at $31 on the first day of trading When this situation occurs, the business and its existing stockholders gjVc away too many shares to raise the new capital, and there is a wealth transfer from existing stockholders to the IPO buyers. Conversely, if the stock price falls on the first day of trading, there is a wealth transfer from the new buyers to the existing shareholders.
IPOs are almost always underpriced, and, in some cases, the under- pricing is dramatic. Various theories have been put forth to explain this phenomenon. The best explanation seems to be that (1) both the current stockholders and the investment bankers want to create excitement about the business, and a big price run-up does that; (2) a small percentage of the stock generally is offered to the public, so current stockholders give away less than they appear to; and (3) IPO firms generally plan to have follow-on stock issues in the near future, and the best way to ensure the success of future issues is to have a successful IPO.
Selling Procedures Once the issuer and its investment banker have decided how much money to raise, the types of securities to issue, and the basis for pricing the issue, they prepare and file a registration statement and a prospectus. It generally takes about 20 days for the issue to be approved by the SEC. The final price of the stock—or the interest rate on a bond issue—is set at the close of business on the day the issue clears the SEC, and the securities are offered to the public the following day.
Buyers are required to pay for securities within ten days, and the investment banker must pay the issuing firm within four days of the official commencement of the offering. Typically, the banker sells the securities within a day or two after the offering begins, but on occasion, the banker miscalculates, sets the offering price too high, and thus is unable to move the issue. At other times, the market declines during the offering period, forcing the banker to reduce the price of the stock or bond. In either instance, on an underwritten offering, the firm receives the dollar amount that was agreed on, so the banker must absorb any losses incurred.
Because they are exposed to large potential losses, investment bankers typically do not handle the purchase and distribution of issues singlehandedly unless the issue is a very small one. If the sum of money involved is large, investment bankers form underwriting syndicates to minimize the risk each
Chapter 7 Supplement: Classified Stock . . .
banker carries. The banking house that sets up the deal is called the lead, or managing, underwriter. In addition to the underwriting syndicate, on larger offerings still more investment bankers are included in a selling group, which handles the distribution of securities to individual investors. The sell- ing grouP includes all members of the underwriting syndicate, plus dealers who take relatively small percentages of the total issue from the members of the underwriting syndicate. Thus, the underwriters act as wholesalers, while members of the selling group act as retailers. The number of houses in a selling group depends on the size of the issue and the number and types of buyers. For example, the selling group that handled a $92 million municipal bond issue for Adventist Health System consisted of three members, while the one that sold $1 billion in junk (B-rated) bonds for National Medical Enterprises consisted of eight members. (Large security issues are announced in the Wall Street Journal and other publications by advertisements placed by the underwriters, called tombstones. Check several recent issues of the Journal to see if any healthcare issues are advertised.)
Still, some new issues are sold without an underwriting syndicate. In an unsyndicated stock offering, the managing underwriter, acting alone, sells the issue entirely to one or more institutional investors. This type of offering can be thought of as a private placement through an investment banker. (As discussed in the chapter, it is possible to do a private placement without using an investment banker.) The motivating force behind this type of offering is, of course, money. The fees that issuers pay on a syndicated offering can run about I percentage point higher than those on an unsyndicated offering. Furthermore, although total fees are lower on an unsyndicated offering, the lead (and only) underwriter usually ends up with more of the proceeds because it does not have to share them with an underwriting syndicate.
Even after an issue is sold, the job of the investment banker may not be finished. In the case of an IPO, the investment banker is obligated to maintain a market in the stock to establish its liquidity. In other words, the banker must hold an inventory of shares and stand ready to buy and sell the stock if no matching orders materialize for the trades initiated in the second- ary market. In doing so, investment bankers keep their corporate customers happy and attract future IPO business.
Shelf Registrations The selling procedures described to this point apply to most security sales. However, under SEC Rule 415, larger firms that issue securities frequently may file a master registration statement with the SEC and then file only a short-form update prior to each offering. Under this rule, it is possible to decide to issue securities today and sell them tomorrow. The “quick” proce- dure is called a shelf registration because the issuer puts its new securities “on
330 Understanding Healthcare Finance Management
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the shelf’ when it files the master registration and can take them “off th shelf’ and sell them to investors when it believes that conditions are “right ” Businesses with less than $150 million market value in float—stock held by outside investors—cannot use shelf registrations. The reason for this limita- tion is to protect investors who may not be able to access adequate financial data about a smaller firm in the short time between the announcement of the offering and the actual sale. Shelf registrations are advantageous to the issuer because overall costs are lower and the firm has more control over the timing of the issue.
SELF-TEST QUESTIONS 1. What are the key features of securities markets regulation?
2. What types of decisions must the issuer and its investment banker make?
3. What is tire difference between an underwritten issue and a best- efforts issue?
4. Are there any conflicts that might arise between the issuer and the investment banker when setting the offering price on a stock issue?
5. What is a shelf registration?
Supplement Key Concepts This chapter supplement contains some additional material on equity financ- ing and how securities are brought to market. Here are its key concepts: i . *
• Corporations, especially start-up businesses, occasionally use classified stock to meet special needs. Generally, when special classifications of stock are used, one type is designated Class A, another Class B, and so on.
• Preferred stock, which is sometimes used by investor-owned firms, is a hybrid: It is similar to debt in some respects and to common stock in other ways. Accountants classify preferred stock as equity, so it is shown on the balance sheet as an equity account. However, from a financial management perspective, preferred stock is closer in nature to debt than to equity.
• Preferred stock is valued in one of two ways. If the stock is perpetual preferred, the stock is valued using perpetuity valuation techniques. If the stock has a limited life, it is valued like debt securities.
r... Chapter 7 Supplement: Classified Stock . . 331• Securities markets are regulated at the national level by the Securities and Exchange Commission (SEC) and at the state level by state agencies, which are often called corporation commissions.
• An investment banker assists in the issuing of securities by helping the business determine the size of the issue and the type of securities to be used; establishing the selling price; selling the issue; and, in some cases, maintaining an aftermarket for the securities.
This concludes our discussion of the institutional features associ- ated with equity financing.
Supplement Websites
The following websites pertain to this chapter supplement:
• To learn about regulation, see the SEC site at www.sec.gov. In addition to providing a great deal of information about the SEC, the site features recent corporate filings. Click on the Search EDGAR for Company Filings box in the right column of the page. Also, see the FINRA site at www.finra.org.
• To learn more about investment banking, see any of the websites of the investment bankers listed in Exhibit S7.1. For example, see the Morgan Stanley site at www.morganstanley.com. Then, click on Institutional Services followed by Investment Banking.
C hapter 7 Supplem
ent
CHAPTER
8LEASE FINANCING Learning Objectives After studying this chapter, readers should be able to
• describe the different types of leases, • explain how lease financing affects financial statements and taxes, • analyze basic lease transactions from the perspectives of both the
lessee and the lessor, and • discuss the factors that create value in lease transactions.
Introduction
Businesses generally own fixed (capital) assets, but it is the use of the build- ings and equipment that is important to the business, not their ownership. One way to obtain the use of such assets is to raise debt or equity capital and then use this capital to buy the assets. An alternative way to obtain the use of fixed assets is to lease them. Prior to the 1950s, leasing was generally associ- ated with real estate—land and buildings. Today, almost any kind of fixed asset can be leased.
Leasing is used extensively in the health services industry. For example, it is estimated that 35 percent to 40 percent of all medical equipment used in the United States is leased. In 2013 alone, healthcare providers leased about $10 billion worth of equipment. Diagnostic imaging devices account for about half of all provider leasing, with a typical lease term of about five years. In addition to diagnostic equipment, there has been increasing use of leasing to acquire information technology, which is consuming a larger and larger proportion of healthcare businesses’ capital expenditures.
| Lease Parties and Types There are two parties to any lease transaction. The user of a leased asset is called the lessee, while the owner of the property—usually the manufacturer or a leasing company—is called the lessor. (“Lessee” is pronounced “less-ee” [not “lease-ee”], and “lessor” is pronounced “less-or.”)
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334 Understanding Healthcare Finance Management
Historically, leases have been classified in one of three categories- (j operating leases, (2) financial leases, and (3) combination leases. In this sec tion, we discuss these informal classifications. In later sections, we will, discuss more formal classifications used by accountants and by the Internal Revenue Service (IRS).
Operating Leases Operating leases, sometimes called service leases, generally provide for both financing and maintenance in addition to use of the asset. IBM was one of the pioneers of operating lease contracts. Computers and office copiers together with automobiles, trucks, and medical diagnostic equipment—are the primary types of assets involved in operating leases. Ordinarily, operating leases require the lessor to maintain and service the leased equipment, and the cost of the maintenance is built into the lease payments.
Another important characteristic of operating leases is partial amorti- zation. In other words, the payments required under the lease contract are not sufficient for the lessor to recover the full cost of the equipment. How- ever, the lease contract is written for a period considerably shorter than the expected economic life of the leased asset, and the lessor expects to recover all costs eventually by lease renewal payments, by releasing the equipment to other lessees, or through sale of the equipment.
Finally, operating leases often contain a cancellation clause, which gives the lessee the right to cancel the lease and return the equipment before the expiration of the basic lease agreement. This feature is important to the lessee because it means that the equipment can be returned if it is rendered obsolete by technological advances or if it is no longer needed because of a decline in the lessee’s business.
Financial Leases Financial leases, which are also called capital leases, are differentiated from operating leases in that they (1) typically do not provide for maintenance service, (2) typically are not cancelable, (3) generally are executed for a period that approximates the useful life of the asset, and hence (4) are fully amortized—that is, the lessor receives rental payments equal to the full cost of the leased asset plus a return on the funds employed.
In a typical financial lease, the lessee selects the item it requires and negotiates the price and delivery terms with the manufacturer. The lessee then arranges to have a leasing firm (lessor) buy the equipment from the manufac- turer, and the lessee simultaneously executes a lease agreement with the lessor. The lessee is generally given an option to renew the lease at a reduced rate upon expiration of the initial lease agreement. However, under a “pure” finan- cial lease, the initial lease cannot be canceled. Also, the lessee generally pays the insurance premiums and any property taxes due on the leased property.
Chapter 8: Lease Financing 335
The terms of the lease call for full amortization of the lessor’s invest- ment plus a rate of return on the unamortized balance, which is close to the percentage rate the lessee would have paid on a secured term loan. For example, if a radiology group practice would have to pay 10 percent for a term loan to buy an X-ray machine, the lessor would build a rate of about [0 percent into the lease contract. The parallel to borrowing is obvious in a financial lease. Under a secured loan arrangement, the lender would normally receive a series of equal payments just sufficient to amortize (pay off) the loan and to provide a specified rate of return on the outstanding loan bal- ance. Under a financial lease, the lease payments are set up exactly the same way—the payments are just sufficient to return the full purchase price to the lessor, plus a stated return on the lessor’s investment.
A sale and leaseback is a special type of financial lease, often used with real estate, that can be arranged by a user that currently owns some asset. Here, the user sells the asset to another party and simultaneously executes an agreement to lease the property back for a stated period under specific terms. In a sale and leaseback, the lessee receives an immediate cash payment in exchange for a future series of lease payments that must be made to rent the asset sold.
Combination Leases Although the distinction between operating and financial leases has historical significance, today many lessors offer leases under a wide variety of terms. Therefore, in practice, leases often do not fit exactly into the operating lease or financial lease category but rather combine some features of each. For example, many of today’s financial leases contain cancellation clauses, which historically have been associated only with operating leases. However, when used in financial leases, these clauses generally include prepayment provisions whereby the lessee must make penalty payments sufficient to enable the lessor to recover some or all of the remaining lease payments.
1. What is the difference between an operating lease and a financial lease?
2. What is a sale and leaseback? 3. Explain the features of a combination lease.
SELF-TEST QUESTIONS
Per Procedure Versus Fixed Payment Leases
Lease (rental) payments on operating leases can be structured in two different ways. Under fixed payment terms, an agreed-upon fixed amount is made to the lessor periodically—usually monthly. With this type of payment, the cost
336 Understanding Healthcare Finance Management
to the lessee is known with certainty. Under per procedure (per use) terms fixed amount is paid each time the equipment is used. In essence, a per ' * cedure lease converts a lessee’s fixed cost for the equipment (which is jpj? pendent of volume) into a variable cost (which is directly related to volum We will have more to say about per procedure leases later in the chapter
SELF-TEST QUESTION
LASIK and Per Use Leases LASIK —commonly referred to as laser eye surgery or laser vision correction —is a type of refractive surgery for the correction of myopia, hypermetropia, and astigmatism. The surgery is performed by an ophthalmologist who uses a laser to reshape the eye’s cornea to improve visual acuity. For most patients, LASIK provides a permanent alternative to eyeglasses or contact lenses. As of 2014, more than 12 million such procedures have been performed in the United States.
LASIK surgery was first approved by the Food and Drug Administration for use in the United States in the early 1990s, after its suc- cessful application in other countries. The equip- ment itself costs about $100,000 and, while cost to patients is highly variable, it averages about $2,000 per eye. Initially, there was significant uncertainty regarding the effectiveness and patient acceptance of the procedure, and hence the volume of surgeries was highly speculative. The end result was that most ophthalmologists were unwilling to risk the $100,000 purchase price.
To encourage widespread use, the manufac- turer, along with other lessors, offered to lease the equipment to physicians on a per procedure (per use) basis. The lease required no upfront payment and the lessor handled equipment maintenance and any required repairs. In addi- tion, the lessor provided delivery and installation along with all required technical training for a per use charge of roughly $800. The end result
(continued)
Tax Effects
For both investor-owned and not-for- profit healthcare businesses, tax effects can play an important role in the lease-versus- buy decision.
Investor-Owned (Taxable) Businesses For investor-owned businesses, the full amount of lease payments is a tax- deductible expense for the lessee provided that the IRS agrees that a particular contract is a genuine lease and not sim- ply a loan that is called a lease. Thus, it is important that a lease contract be writ- ten with terms that are acceptable to the IRS. A lease that complies with all of the IRS requirements for taxable businesses is called a guideline., or tux-oriented, louse. In a guideline lease, ownership tax benefits (primarily depreciation) accrue to the les- sor and the lessee’s lease payments are fully tax deductible. A lease that does not meet the tax guidelines is called a non-guideline, or non-tux-oriented lease. For this type of lease, the lessee can deduct only the implied interest portion of each lease pay- ment. However, the lessee is effectively the owner of the leased equipment; thus, the lessee, rather than the lessor, receives the tax depreciation benefit.
Chapter 8: Lease Financing
The main provisions of the tax guidelines are as follows:
The lease term, including any extensions or renewals at a fixed rental rate, must not exceed 80 percent of the estimated useful life of the equipment at the commencement of the lease transaction. Thus, at the projected end of the lease, the property must have an estimated remaining life equal to at least 20 percent of its original life. Furthermore, the remaining useful
(continued from previous page)
was a fixed contribution of about $1,200 for each procedure performed, which first covers all other operating costs and then flows to profit. Under a traditional fixed payment lease, the risk of low volume is borne by the practice, but under a per use lease, this risk is assumed by the lessor. At anticipated volumes, the per use lease cost more than a fixed payment lease, but the per use lease provides protection (insurance) for the lessee against low volumes.
Because of the attractiveness of the per use lease financing option to ophthalmolo- gists, LASIK surgery took off like gangbusters and today remains one of their leading revenue sources.
life must not be less than one year. This requirement limits the maximum term of a guideline lease to 80 percent of the asset’s useful life. Note that an asset’s useful life is normally much longer than its tax depreciation class life.
• The equipment’s estimated value (in constant dollars without adjustment for inflation) at the projected expiration of the lease must equal at least 20 percent of its value at the start of the lease. Note that the estimated value of the asset at the end of the lease is called the residual value. This requirement also has the effect of limiting the maximum lease term.
• Neither the lessee nor any related party can have the right to purchase the property from the lessor at a price substantially less than its fair market value. • Neither the lessee nor any related party can pay or guarantee payment
of any part of the price of the leased equipment. Simply put, the lessee cannot make any investment in the equipment, other than through the lease payments.
• The leased equipment must not be “limited use” property, which is equipment that can be used only by the lessee or a related party at the end of the lease.
The reason for the IRS’s concern about lease terms is that, without restrictions, a business can set up a “lease” transaction that calls for rapid lease payments, which would be deductible from taxable income. The effect would be to depreciate the equipment over a much shorter period than the IRS allows in its depreciation guidelines. For example, suppose that New England Laboratories, Inc., an investor-owned corporation that owns clinical
338 Understanding Healthcare Finance Management
laboratories in New Hampshire, Maine, Massachusetts, and Vermont p| to acquire a $2 million computer that has a three-year life for tav According to current tax laws (Modified Accelerated Cost Recovery s [MACRS]), the annual depreciation allowances would be $660,000 ' 1; $900,000 in Year 2; $300,000 in Year 3; and $140,000 in Year 4. England Laboratories were in the 40 percent federal-plus-state tax br "i™ the depreciation would provide a tax savings of 0.40 x $660,000 = $264 ni in Year 1; $360,000 in Year 2; $120,000 in Year 3; and $56,000 in Year 4 f * a total savings of $800,000. At a 6 percent discount rate, the present value of these tax savings would be $757,441.
Now, suppose the firm could acquire the computer through a one-ycar lease arrangement with Bank of Boston for a payment of $2 million, with a one-dollar purchase option. If the $2 million payment were treated as a lease payment, it would be fully deductible, so it would provide tax savings of 0.40 x $2,000,000 = $800,000 versus a present value of only $757,441 for the depreciation shelters associated with ownership. Thus, the lease payment and the depreciation would both provide the same total amount of tax sav- ings—40 percent of $2 million, or $800,000—but the savings would conic in faster, and hence have a higher present value, with the one-year lease. This acceleration would benefit businesses, but it would be costly to the govern- ment and hence to individual taxpayers. For this reason, the IRS has estab- lished the rules just described for defining a lease for tax purposes.
Even though leasing can be used only within limits to speed up the effective depreciation schedule, there are still times when substantial tax ben- efits can be derived from a leasing arrangement. For example, if an investor- owned hospital has a large construction program that has generated so much depreciation that it has no current tax liabilities, then depreciation shelters arc not very useful. In this case, a leasing company set up by a profitable busi- ness, like General Electric, can buy the equipment, receive the depreciation shelters, and then share these benefits with the hospital by charging lower lease payments.1 This issue will be discussed in detail later in the chapter, but the point to be made now is that if businesses are to obtain tax benefits from leasing, the lease contract must be written in a manner that will qualify it as a true lease under IRS guidelines. Any questions about the tax status of a lease contract must be resolved by the potential lessee prior to signing the contract.
Not-for-Profit (Tax-Exempt) Businesses Not-for-profit businesses also benefit from tax laws, but in a different way. Because not-for-profit corporations do not obtain tax benefits from depre- ciation, the ownership of assets has no tax-related value. However, lessors, which are all taxable businesses, do benefit from ownership. This benefit,
Chapter 8: Lease Financing 339
in turn, can be shared with the lessee in the form of lower rental payments. \jote, however, that the cost of tax-exempt debt to not-for-profit firms can be lower than the after-tax cost of debt to taxable firms, so leasing is not automatically less costly to not-for-profit businesses than borrowing in the tax-exempt markets and buying.
A special type of financial transaction—called a tax-exempt lease—has been created for not-for-profit businesses. Legally, this transaction is not really a lease, but it has all of the general characteristics of one. The major difference between a tax-exempt lease and a conventional lease is that the implied interest portion of the lease payment is not classified as taxable income to the lessor. Thus, a portion of the lease payment received by the lessor is exempt from federal income taxes. The rationale for this tax treat- ment is that the interest paid on most debt financing used by not-for-profit organizations is tax exempt to the lender, and a lessor is, in actuality, a lender. Tax-exempt leases provide a greater after-tax return to lessors than do con- ventional leases, so some of this “extra” return can be passed back to the lessee in the form of lower lease payments. Thus, a not-for-profit lessee’s payments on tax-exempt leases can be lower than the payments on conven- tional leases.
1. What is the difference between a guideline and a non-guideline lease?
2. What are some provisions that would make a lease non-guideline? 3. Why should the IRS care about lease provisions? 4. What is a tax-exempt lease?
SELF-TEST QUESTIONS
Balance Sheet Effects
Under certain conditions, neither the leased asset nor the liabilities under the lease contract appear on the lessee’s balance sheet. In such cases, leasing is often called off-balance-sheet financing. This point is illustrated in Exhibit 8.1 by the balance sheets of two hypothetical firms—B and L. Initially, the balance sheets of both firms are identical, and they both have debt (debt-to- assets) ratios of 50 percent. Each firm decides to acquire a fixed asset that costs $100. Firm B borrows $100 and buys the asset, so both an asset and a liability appear on its balance sheet and its debt ratio rises from 50 percent to 75 percent. Firm L leases the equipment. The lease may call for fixed charges as high as or even higher than the amount borrowed by Firm B, and the obli- gations assumed under the lease may have equal or even more potential to force Firm L into bankruptcy, but the firm’s debt ratio remains at 50 percent.
34© Understanding Healthcare Finance Management
EXHIBIT 8.1 Effects of
Leasing on Balance Sheets
Before asset increase:
Firms B and L
Current assets $ 50 Fixed assets 50 Total assets $100
Debt/assets ratio
Debt $ 50 Equity ___50
$100
50%
After asset increase:
Firm B, Which Borrows and Buys
Current assets $ 50 Fixed assets 150 Total assets $200
Debt $150 Equity ___50
$200
Debt/assets ratio 75%
_______Firm L, Which Leases
Current assets $ 50 Debt $ 50 Fixed assets 50 Equity 50 Total assets $100 $7oo
Debt/assets ratio 5oo/o
To partially correct this problem, current accounting rules require firms that enter into certain leases to restate their balance sheets to report the leased asset as a fixed asset and the present value of the future lease payments as a liability. This process is called capitalizing the lease; hence, such a lease is called a capital lense. The net effect of capitalizing the lease is to cause firms B and L to have similar balance sheets, both of which will resemble the one shown for Firm B.
A lease is classified as a capital lease and thus is capitalized and shown directly on the balance sheet, if one or more of the following conditions exist:
® Under the terms of the lease, ownership of the property is effectively transferred from the lessor to the lessee.
• The lessee can purchase the property at less than its true market value when the lease expires.
• The lease runs for a period equal to or greater than 75 percent of the asset’s life. Thus, if an asset has a ten-year life and the lease is written for eight years, the lease must be capitalized.
• The present value of the lease payments is equal to or greater than 90 percent of the initial value of the asset. The discount rate used to calculate the present value of the lease payments must be the lower of (1) the rate used by the lessor to establish the lease payments, which is discussed later in the chapter, and (2) the rate of interest that the lessee would have to pay for new debt with a maturity equal to that of the lease. Note that any maintenance payments embedded in the lease payment must be stripped out prior to checking this condition.
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The logic behind capitalization is as follows. If a firm signs a capital » contract, its obligation to make lease payments is just as binding as if it T ’ med a loan agreement; failure to make lease payments has the potential M bankrupt a firm, just as failure to make principal and interest payments on loan can result in bankruptcy. Therefore, under most circumstances, a capi- | lease has the same impact on a firm’s financial condition as does a loan, so the firm’s effective debt ratio is raised. If the firm had previously established 1 target capital structure, and if there is n0 reason to think that the optimal capital structure has changed, then additional equity support is required to use lease financing, just as additional equity support is required to use debt financing. In other words, leasing uses up debt capacity. If disclosure of the lease in Exhibit 8. l were not made, Firm L’s investors could be deceived into thinking that its financial position is stronger than it really is. Thus, even before businesses were required to place financial leases on the balance sheet, they were required to disclose the existence of long-term leases in the notes section of their financial statements. The question of whether investors were truly deceived was debated but never resolved. Accountants who believed strongly in efficient markets thought that investors were not deceived and that footnotes were sufficient, while those who questioned market efficiency thought that all leases should be capitalized. Current accounting requirements are a compromise between these two positions, although one that is tilted heavily toward those wrho favor capitalization. Note, however, that account- ing rules changes are on the way and, at some point in time, almost all leases will be reported directly on the balance sheet.
Regardless of current accounting rules, from an economic (financial) per- spective, a financial lease has the same economic consequences for a business as a loan in which the asset is pledged as
FASB Changes to Lease Accounting Guidelines Financial Accounting Standards Board (FASB) Statement 13, “Accounting for Leases,” which has been in effect since 1977, spells out in detail the conditions under which a lease must be capital- ized and the procedures for capitalizing it. FASB is the primary organization promulgating the rules that form the basis of generally accepted accounting principles (GAAP), which, in turn, guide the preparation of financial statements. FASB is currently reexamining its guidelines for lease accounting, with the expectation that new rules will be required of all businesses by 2017.
Although a complete discussion of the changes is beyond the scope of this text, the most important proposed change is that leases would no longer be classified by accountants as operating or capital. Rather, all fixed payment leases would be accounted for in the same way on the balance sheet—there would be no difference between short-term leases longer than 1 year and long-term leases. All leased property would be listed by les- sees on the asset side as “right-to-use assets” and on the liability side as “lease liabilities.”
Over the term of the lease, leased assets would be depreciated by the straight-line method and lease liabilities would be decreased by the rental payments made. For all practical purposes, the leased assets and liabilities will balance one another, so the primary effect will be to increase both sides of the balance sheet by a like amount. The ultimate purpose of the proposed rule is to eliminate operating leases as a source of off- balance-sheet financing and hence report all leases directly on the balance sheet.
collateral. Thus, leases are considered the same as debt for capital structure purposes, and they have roughly the same effects as debt on the fina ' condition of the firm.
However, there are some legal differences between loans and lease mostly involving the rights of lessors versus lenders when a business in finan' cial distress reorganizes or liquidates. In most financial distress situations lessors fare better than lenders do, so lessors may be more willing than would lenders to deal with firms in poor financial condition. At a minimum, lessors may be willing to accept lower rates of return than lenders would when deal ing with financially distressed firms because their risks are lower.
In closing, note that the rules that accountants currently follow in decid- ing whether to capitalize a lease are not identical to the rules that the IRS f0|. lows to decide whether the lease is a guideline lease. In most cases, however leases that meet IRS guidelines are operating leases that will not be capitalized while leases that do not meet IRS guidelines are financial leases that will be capi- talized. Remember, however, that even operating (non-capitalized) leases must be disclosed in the notes section of the organization’s financial statements.
SELF-TEST QUESTIONS 1. Why is lease financing sometimes called off-balance-sheet
financing? 2. How are leases currently accounted for in a lessee’s financial
statements? 3. What accounting rules changes are being considered for lessees?
Evaluation by the Lessee
Leases are evaluated by both the lessee and the lessor. The lessee must deter- mine whether leasing an asset is less costly than obtaining equivalent alterna- tive financing and buying the asset, and the lessor must decide what the lease payments must be to produce a rate of return consistent with the riskiness of the investment. This section focuses on the lessee’s analysis.
A degree of uncertainty exists regarding the theoretically correct way to evaluate lease-versus-purchase decisions, and complex decision models have been developed to aid in the analysis. However, the simple analysis given here, coupled with judgment, is sufficient to prevent a lessee from entering into a lease agreement that is clearly not in its best interests. In the typical case, the events leading to a lease arrangement follow this sequence:
• The business decides to acquire a particular building or piece of equipment; this decision is based on the standard capital budgeting procedures discussed in chapters 11 and 12. The decision to acquire the asset is not an issue in the typical lease analysis; this decision was
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niade previously as part of the capital budgeting process. In lease analysis, we are concerned simply with whether to obtain the use of the property by lease or by purchase (how to finance the acquisition).
• Once the business has decided to acquire the asset, the next question is how to finance its acquisition. A well-run business does not have excess cash lying around, and even if it does, there are opportunity costs associated with its use.
• Funds to purchase the asset can be obtained by borrowing; by retaining earnings; or, if the business is investor owned, by selling new equity. If the firm is not-for-profit, perhaps the funds can be raised by soliciting contributions for the project. Some combination of these sources can also be used. Alternatively, the asset can be leased.
Because a lease is roughly comparable to a loan in the sense that both have a similar impact on a business’s financial condition, the appropri- ate comparison when making lease decisions is the cost of lease financing versus the cost of debt financing. The comparison of lease financing to debt financing is valid regardless of how the asset actually would be financed if it were not leased. The asset may be purchased with available cash if not leased or financed by a new equity sale or a cash contribution. However, because leasing is a substitute for debt financing and hence uses up a business’s debt capacity, the appropriate comparison would still be to debt financing.
Simplified Example To better understand the basic elements of lease analysis, consider this simpli- fied example. Nashville Radiology Group (the Group) needs to use a $100 piece of diagnostic equipment for two years, and the Group must choose between leasing and buying the machine. (The actual cost is $100,000, but let’s keep the numbers simple.) If the Group purchases the machine, the bank will lend the Group the needed $100 at a rate of 10 percent on a two-year, simple interest loan. Thus, the Group would have to pay the bank $10 in interest at the end of each year, plus return the $100 in principal at the end of Year 2. For simplicity, assume that, if the Group purchases the machine, it can depreciate the entire cost over two years for tax purposes by the straight- line method, resulting in tax depreciation of $50 in each year. Furthermore, the Group’s tax rate is 40 percent. Thus, the depreciation expense produces a tax savings, or tax shield, of $50 x 0.40 = $20 each year. Also for simplicity, assume that the machine’s value at the end of two years (its residual value) is estimated to be $0.
Alternatively, the Group can lease the asset under a guideline lease for two years for a payment of $55 at the end of each year. The analysis for the lease-versus-buy decision consists of (1) estimating the cash flows associated with borrowing and buying the asset—that is, the flows associated with debt financing; (2) estimating the cash flows associated with leasing the asset; and
344 Understanding Healthcare Finance Management
(3) comparing the two financing methods to determine which has the low cost. Here are the borrow-and-buy flows:
Cash Flows if the Group Buys
Equipment cost
Loan amount Interest expense Tax savings from interest Principal repayment Tax savings from depreciation Net cash flow
Tear 0 Tear 1 Tear 2
($100)
100 ($10) ($ 10) 4 4
( 100) 20 20
$ 0 $14 (F86)
The net cash flow is zero in Year 0, positive in Year 1, and negative in Year 2. Because the operating cash flows (the revenues and operating costs) will be the same regardless of whether the machine is leased or purchased they can be ignored. Cash flows that are not affected by the decision at hand are said to be non-incrementalto the decision. Here are the cash flows associ- ated with the lease:
Cash Flows if the Group Leases Tear 0 Tear 1 Tear 2
Lease payment ($55) ($55) Tax savings from payment 22 22 Net cash flow $0 ($33) ($33)
Note that the two sets of cash flows reflect the tax savings associated with interest expense, depreciation, and lease payments, as appropriate. If the lease had not met IRS guidelines, ownership would have resided with the lessee, and the Group would have depreciated the asset for tax purposes whether it had been “leased” or purchased. Furthermore, only the implied interest portion of the lease payment would be tax deductible. Thus, the analysis for a non-guideline lease would consist of simply comparing the after-tax financing flows on the loan with the after-tax lease payment stream.
To compare the cost streams of buying and leasing, we must put them on a present value basis. As we will explain later, the correct discount rate is the lessee’s after-tax cost of debt, which for the Group is 10% x (1 - T) = 10% x (1 - 0.4) = 6%. Applying this rate, we find the present value cost of buying to be $63.33 and the present value cost of leasing to be $60.50. Because leasing has the lower present value of costs, it is the less costly financ- ing alternative, so the Group should lease the asset.
This simplified example shows the general approach used in lease analysis, and it also illustrates a concept that can simplify the cash flow estima- tion process. Look back at the loan-related cash flows if the Group buys the machine, which consist of the interest expense, tax savings from interest, and
Chapter 8: Lease Financing 345
rincipal repayment. The after-tax loan-related flows are -$6 in year 1 and $106 in year 2. When these flows are discounted to Year 0 at the 6 percent after-tax cost of debt, their present value is -$100, which is the negative of the loan amount shown in Year 0. This equality results because we first used the cost of debt to estimate the future financing flows, and we then used this same rate to discount the flows back to Year 0, all on an after-tax basis. In effect, the loan amount positive cash flow and the Ioan cost negative cash flows cancel one another out. Here is the cash flow stream associated with buying the asset after the Year 0 loan amount and the related Year 1 and Year 2 flows have been removed:
Cash Flows if the Group Buys Year 0 Year 1 Year 2
Cost of asset ($100) Tax savings from depreciation $20 $20 Net cash flow ($100) $20 $20
The present value cost of buying here is $63.33, which is the same number we found earlier. The two approaches will always produce consistent estimates regardless of the specific terms of the debt financing—as long as the discount rate is the after-tax cost of debt, the cash flows associated with the loan can be ignored.
More Realistic Example To examine a more realistic example of lease analysis, consider the following lease-versus-buy decision facing the Nashville Radiology Group:
• The Group plans to acquire a new computer system that will automate the Group’s clinical records as well as its accounting, billing, and collection processes. The computer has an economic life of eight years and costs $200,000, delivered and installed. However, the Group plans to lease the equipment for only four years because it believes that computer technology is changing rapidly and wants the opportunity to reevaluate the situation at that time.
• The Group can borrow the required $200,000 from its bank at a before-tax cost of 10 percent.
• The computer’s estimated scrap value is $5,000 after eight years of use, but its estimated residual value when the lease expires after four years of use is $20,000. Thus, if the Group buys the equipment, it would expect to receive $20,000 before taxes when the equipment is sold in four years.
• The Group can lease the equipment for four years at a rental charge of $57,000, payable at the beginning of each year, but the lessor will
346 Understanding Healthcare Finance Management
own the equipment upon expiration of the lease. (The lease payment schedule is established by the potential lessor, as described in a later section, and the Group can accept, reject, or negotiate it.)
• The lease contract stipulates that the lessor will maintain the computer at no additional charge to the Group. However, if the Group borrows money to buy the computer, it will have to bear the cost of maintenance, which would be performed by the equipment manufacturer at a fixed contract rate of $2,500 per year, payable at the beginning of each year.
• The computer falls in the MACRS five-year class life, the group’s marginal tax rate is 40 percent, and the lease qualifies as a guideline lease under a special IRS ruling. (Refer to Chapter 1 to review tax depreciation, if necessary.)
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Dollar Cost Approach Exhibit 8.2 shows the steps involved in a complete dollar cost analysis. As in the simplified example, our approach here is to compare the dollar cost of owning (borrowing and buying) to the dollar cost of leasing. All else the same, the lower-cost alternative is preferable. Part I of the exhibit is devoted to the costs of borrowing and buying. Here, line 1 shows the equipment’s cost, and line 2 shows the maintenance expense; both are cash costs or out- flows. Note that whenever an analyst is setting up cash flows on a time line, one of the first decisions to be made is what time interval will be used—that is, months, quarters, years, or some other period. As a starting point, we generally assume that all cash flows occur at the end of each year. If, at some point later in the analysis, we conclude that another interval is better, we will change it. Longer intervals—such as years—simplify the analysis but intro- duce some inaccuracies because all cash flows do not occur at year-end. For example, tax benefits occur quarterly because businesses pay taxes on a quar- terly basis. On the other hand, shorter intervals—such as months—often are used for lease analyses because lease payments typically occur monthly. For ease of illustration, we are using annual flows in this example.
Line 3 shows the maintenance tax savings, and because maintenance expense is tax deductible, the Group saves 0.40 x $2,500 = $1,000 in taxes by virtue of paying the maintenance fee. Line 4 shows the depreciation tax savings, which is the depreciation expense multiplied by the tax rate. For example, the MACRS allowance for the first year is 20 percent, so the depre- ciation expense is 0.20 x $200,000 = $40,000 and the depreciation tax sav- ings is 0.40 x $40,000 = $16,000.
Lines 5 and 6 show the residual value cash flows. The residual value is estimated to be $20,000, but the tax book value after four years of deprecia-
tion is $34,000. Thus, the Group is losing $14,000 for tax purposes, which produces the 0.4 x $14,000 = $5,600 tax savings shown as an inflow in line 6.
Chapter 8: Lease Financing
Yearo Yeari Year 2 Year 3 Year 4
I Cost of Owning (Borrowing and Buying) \ Net purchase price ($200,000) 2. Maintenance cost (2,500) 3. Maintenance tax savings 1,000 4. Depreciation tax savings 5. Residual value 6. Residual value tax 7. Net cash flow 8. pv cost of owning =
($ 201,500)
($ 126,987)
EXHIBIT 8.2 Lessee’s Dollar Cost Analysis
($ 2,500) ($ 2,500) 1,000
16,000 1,000 25,600
$14,500
$24,100
($ 2,500) 1,000
15,200 $ 9,600 20,000
5,600 $ 13,700 $35,200
//. Cost of Leasing 9. Lease payment 10. Tax savings 11. Net cash flow 12. PV cost of leasing =
($ 57,000) ($57,000) ($57,000) ($57,000) 22,800 22,800 22,800 22,800 ($ 34,200) ($34,200) ($34,200) ($34,200) $
0 ($ 125,617)
///. Cost Comparison 13. Net advantage to leasing (NAL) = PV cost of leasing - PV cost of owning
= - $ 1 2 5 , 6 1 7 - ( - $ 1 2 6 , 9 8 7 ) = $ 1 , 3 7 0 .
Notes: l.The MACRS depreciation allowances are 0.20,0.32,0.19, and 0.12 in years 1 through 4, respectively. 2. In practice, a lease analysis such as this one would be done on a monthly basis using a spreadsheet program.
Line 7, which sums the component cash flows, shows the net cash flows asso- ciated with borrowing and buying.
Part II of Exhibit 8.2 contains an analysis of the cost of leasing. The lease payments, shown in line 9, are $57,000 per year; this rate, which includes maintenance, was established by the prospective lessor and offered to the Group. If the Group accepts the lease, the full amount will be a deductible expense, so the tax savings, shown in line 10, is 0.40 x Lease pay- ment = 0.40 x $57,000 = $22,800. The net cash flows associated with leasing are shown in line 11.
The final step is to compare the net cost of owning with the net cost of leasing. First, we must put the annual cash flows associated with owning and leasing on a common basis by converting them to present values, which brings up the question of the proper rate at which to discount the net cash flows. We know that the riskier the cash flows, the higher the discount rate used to find the present value will be. This same principle was observed in our discussion of security valuation, and it applies to all discounted cash flow analyses, including lease analysis. Just how risky are the cash flows under consideration here? Most of them are relatively certain, at least when com- pared with the types of cash flow estimates associated with stock investments
L
348 Understanding Healthcare Finance Management
or with the Group’s operating cash flows. For example, the loan paymc schedule is set by contract, as is the lease payment schedule. The depreciate expenses are also established by law and not subject to change, and the annual maintenance fee is fixed by contract as well. The tax savings are somewhat uncertain, but they will be as projected as long as the Group’s marginal tax rate remains at 40 percent. The residual value is the least certain of the cash flows, but even here, the Group’s management is fairly confident because there arc a great deal of historical data available to help make the estimate
Because the cash flows under the lease and under the borrow-and purchase alternatives are both relatively certain, they should be discounted at a relatively low rate. What market-determined rate is readily available that reflects relatively low risk? Most analysts recommend that the firm’s cost of debt financing be used, and this rate seems reasonable in our example. How- ever, the Group’s cost of debt—10 percent—must be adjusted to reflect the tax deductibility of interest payments because this benefit of borrowing and
buying is not accounted for in the cash flows. Thus, the Group’s effective cost of debt becomes Before-tax cost x (1 - Tax rate) = 10% x 0.6 = 6%.
Accordingly, the cash flows in lines 7 and 11 are discounted at a 6 percent rate. The resulting present values are $126,987 for the cost of owning and $125,617 for the cost of leasing, as shown in lines 8 and 12. Leasing is the lower-cost financing alternative, so the Group should lease, rather than buy,
the computer. The cost comparison can be formalized by defining the net advantage
to leasing (NAL) as follows:
Key Equation 8.i: Net Advantage to Leasing (NAL) NAL = PV cost of leasing - PV cost of owning
= -$125,617 - (-$126,987) = $1,370.
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The positive NAL indicates that leasing creates more value than buy- ing, so the Group should lease the equipment. Indeed, the value of the Group is increased by $1,370 if it leases, rather than buys, the computer.
Percentage Cost Approach The Group’s lease-versus-buy decision can also be analyzed using percentage cost analysis, which involves comparing the effective cost rate on the lease to the effective cost rate on the loan. Signing a lease is similar to signing a loan contract—the firm has the use of the equipment but must make a series of payments under either type of contract. We know the effective cost rate built
Chapter 8: Lease Financing 349
Year 0 Yeari Year 2 Year 3 Year 4
l Leasing cash flow ($34,200) ($34,200) „ IPSS: Owning cash flow (201,500) 14,500 3 Leasing-versus-owning CF $167,300 ($48,700)
($34,200) ($34,200) $ 0 24,100 13,700 35,200
($58,300) ($47,900) ($35,200)
EXHIBIT 8.3 Lessee’s Percentage Cost Analysis
NAL = $1-370. |RR = 5.6%.
into the loan: It is the 6 percent after-tax interest rate. If the after-tax cost rate in the lease is less than 6 percent, there is an advantage to leasing.
Exhibit 8.3 sets forth the cash flows needed to determine the percent- age cost of the lease. Here is an explanation of the exhibit:
• The first step is to calculate the leasing-versus-owning cash flows. We do so by subtracting the owning cash flows shown in line 7 from the leasing cash flows shown in line 11 (see Exhibit 8.2). The differences are the incremental cash flows that relate to the Group if it leases, rather than buys, the computer.
• Note that Exhibit 8.3 consolidates the analysis shown in Exhibit 8.2 into a single set of net cash flows. At this point, we can discount the net (consolidated) cash flows shown in line 3 by 6 percent to obtain the NAL, $1,370. In Exhibit 8.2, we discounted the owning and leasing cash flows separately and then subtracted their present values to obtain the NAL. In Exhibit 8.3, we subtracted the cash flows first to obtain a single set of flows and then found their present value. The end result is the same.
• The consolidated cash flows provide good insight into the economics of leasing. If the Group leases the computer, it avoids having to lay out the cash required to buy the equipment in Year 0, but it is then obligated to make a series of cash outflows for four years. In marketing materials, leasing companies are quick to point out that leasing does not require a large, upfront cash outlay ($167,300 in this example). However, they are not so quick to mention that the “cost” to save this outlay is an obligation to make payments over the next four years. Leasing makes sense financially (disregarding other factors) only if the savings are worth the cost.
• By inputting the leasing-versus-owning cash flows listed in Exhibit 8.3 into a spreadsheet and using the internal rate of return (IRR) function, we can find the cost rate inherent in the cash flow stream: 5.6 percent. This rate is the equivalent after-tax cost rate implied in the lease contract. Because this cost rate is lower than the 6 percent after-tax
350 Understanding Healthcare Finance Management
cost rate on a regular loan, leasing is less expensive than borro •' buying. Thus, the percentage cost analysis confirms the NAL analy
Some Additional Points So far, we have discussed the main features of a lessee’s analysis indud both dollar cost and percentage cost approaches. Before we move on to the lessor’s analysis, note the following points:
• The dollar cost and percentage cost approaches will always lead to the same decision. Thus, one method is as good as the other from a decision standpoint.
• If the net residual value cash flow (residual value and tax effect) is considered riskier than the other cash flows in the analysis, it is possible to account for this differential risk by applying a higher discount rate to this flow, which results in a lower present value. Because the net residual value flow is an inflow in the cost-of-owning analysis, a lower present value leads to a higher present value cost of owning. Thus, increasing residual value risk decreases the attractiveness of owning an asset. For example, assume that the Group’s managers believe that the computer’s residual value is much riskier than the other flows in Exhibit 8.2. Furthermore, they believe that 10 percent, rather than 6 percent, is the appropriate discount rate to apply to the residual value flows. When the Exhibit 8.2 analysis is modified to reflect this risk, the present value cost of owning increases to $129,780, while the NAL increases to $4,163. The riskier the residual value, all else the same, the more favorable leasing becomes, because residual value risk is borne by the lessor. However, all else will generally not be the same. Increasing residual value risk would cause the lessor to increase the lease payment, thereby making the lease less attractive to the lessee.
• As we discuss in Chapter 11, net present value (NPV) is the dollar value of a project, assuming that it is financed using debt and equity financing. In lease analysis, the NAL is the additional dollar value of a project attributable to leasing, as opposed to conventional (debt) financing. Thus, to approximate the value of a leased asset to the firm, we increase the project’s NPV by the amount of NAL:
Key Equation 8.2: Adjusted NPV Adjusted NPV = NPV + NAL.
The value added through leasing, in some cases, can turn unprofitable (negative NPV) projects into profitable (positive adjusted NPV) projects.
Chapter 8: Lease Financing 351
Thus, projects (assets) that are marginally unprofitable when evaluated on the basis of conventional financing should be reevaluated on the basis of lease financing (if available) to see whether alternative financing will make the project financially acceptable.
1. Explain how the cash flows are structured in conducting a dollar- based NAL analysis.
2. What discount rate should be used when lessees perform lease analyses?
3. What is the economic interpretation of the net advantage to leasing? 4. What is the economic interpretation of a lease’s IRR?
Evaluation by the Lessor
Thus far, we have considered lease analysis from the lessee’s viewpoint. It is also useful to analyze the transaction as the lessor sees it: Is the lease a good investment for the party that writes the lease (i.e., the party that buys the asset)? The lessor will generally be a specialized leasing firm; a bank or bank affiliate; or a manufacturer, such as Siemens Healthcare, that uses leasing by an affiliated entity as a marketing tool.
Any potential lessor needs to know the rate of return on the capital invested in the lease. This information is also useful to the prospective lessee because lease terms on large leases are generally negotiated; so, the lessor and the lessee should know one another’s position. The lessor’s analysis involves (1) determining the net cash outlay, which is usually the invoice price of the leased equipment less any lease payments made in advance; (2) determining the periodic cash inflows, which consist of the lease payments minus income taxes and any maintenance expenses the lessor must bear; (3) estimating the after-tax residual value of the property when the lease expires; and (4) deter- mining whether the rate of return on the lease is adequate for the riskiness of the investment.
To illustrate the lessor’s analysis, we assume the same facts for the Nashville Radiology Group lease as well as this situation. The potential lessor is Medicomp, Inc., a commercial leasing company that specializes in leasing computers to healthcare providers. Medicomp’s marginal federal-plus-state tax rate is 40 percent. To provide maintenance to the Group, Medicomp must contract with the computer manufacturer under the same terms avail- able to the Group—that is, $2,500 at the beginning of each year. Medicomp views computer lease arrangements as relatively low-risk investments. There is, however, some small chance of default on the lease, so Medicomp typically assumes that a lease investment is about as risky as buying AA-rated corporate
L
SELF-TEST QUESTIONS
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Understanding Healthcare Finance Management
352
bonds. Because four-year, AA-rated bonds are yielding 9 percent at the time of the analysis, Medicomp can earn an after-tax yield of 9.0% x (1 •pj 9.0% x 0.6 = 5.4% on such investments. Thus, 5.4 percent is the after-tax return that Medicomp can obtain on alternative investments of similar risk (the opportunity cost rate).
The lease analysis from the lessor’s standpoint is developed in Exhibit 8.4. Here, we see that the cash flows to the lessor are similar to those for the lessee shown in Exhibit 8.2. Line 1 shows the purchase price of the com- puter—$200,000. Line 2 shows the maintenance costs, while line 3 lists the tax savings attributable to these costs. Line 4 shows the depreciation tax sav- ings, or tax shields, that accrue to the owner of the computer. In line 5, wc show the annual lease rental payment as an inflow, while the taxes that must be paid on the rental payments are shown in line 6. Lines 7 and 8 show the residual value and resulting taxes (tax savings in this case). Finally, the cash flows are summed in line 9.
The value (NPV) of the lease to Medicomp is found by discounting the line 9 cash flows at the firm’s after-tax opportunity cost of capital—5.4 percent—and then summing the resultant present values. (When using a spreadsheet for the analysis, use the NPV function.) For Medicomp, the NPV of the lease investment is $815, which means that the firm is somewhat better off, on a present value basis, if it writes the lease rather than invests in comparable-risk AA-rated bonds. If the NPV of the lease were negative, Medicomp would be better off investing in the bonds. Because we saw earlier that the lease is also advantageous to the Group, the transaction is beneficial to both the lessee and the lessor.
We can also calculate Medicomp’s expected percentage rate of return on the lease by finding the IRK of the net cash flows shown in line 9 of Exhibit 8.4. Simply use a spreadsheet’s IRR function to find the answer:
EXHIBIT 8.4 Lessor’s Analysis
Yearo Yeari Year 2 Year 3 Year 4
1. Net purchase price ($200,000) 2. Maintenance cost (2,500) ($ 2,500)($ 2,500) ($ 2,500) 3. Maintenance tax savings ; 1,000 1,000 1,000 1,000 4. Depreciation tax savings 16,000 25,600 15,200 $ 9,600 5. Lease payment 57,ooo 57,ooo 57,ooo 57,ooo 6. Tax on lease payment (22,800)(22,800) (22,800) (22,800) 7. Residual value 20,000 8. Taxon residual value 5,600 9. Net cash flow ($ 167,300) co V 0 0 $58,300 $47,900 $35,200
NPV = $815. IRR = 5.6%.
Chapter 8: Lease Financing 353
- 6 percent. Thus, the lease provides a 5.6 percent after-tax return to Medi- comp, which exceeds the 5.4 percent after-tax return available on alternative investments of similar risk: AA-rated, four-year bonds. So, using either the jyjlar-rate-of-return (NPV) method or the percentage-rate-of-return (IRR) method, we obtain the same result: The lease appears to be a satisfactory investment for Medicomp.
Note, however, that the lease investment is actually slightly more risky than the alternative bond investment because the residual value cash flow is less certain than a principal repayment. Thus, Medicomp would probably require a rate of return somewhat above the 5.4 percent promised on the bond investment, and the higher the risk of the residual value, the higher the required return. Also, note that the lessor’s NPV analysis can be extended by using a higher discount rate on the residual value cash flows than that used on the other flows. Doing so lowers the NPV and hence makes the lease investment look less attractive than the bond investment.
1. What discount rate is used in a lessor’s NPV analysis? 2. What is the economic interpretation of the lessor’s NPV? The
lessor’s IRR?
SELF-TEST QUESTIONS
Lease Analysis Symmetry
Let’s stop for a moment and compare the cash flows in exhibits 8.3 and 8.4. Upon examination, we find that the cash flows to the lessee and lessor are symmetrical. They differ in sign, but their values are the same. This sym- metry occurs because there are only two parties to a lease transaction, and our example assumed that the parties would pay the same amount for the computer, pay taxes at the same rate, forecast the same residual value, and so on. Thus, a cash inflow to one party becomes a cash outflow to the other. Taken one step further, if the cost of debt to the lessee in our example had equaled the opportunity cost to the lessor, the NPV to the lessor would be equal, but opposite in sign, to the lessee’s NAL. Therefore, if all of the input values had been the same to both lessee and lessor, Medicomp’s NPV would have been a negative $1,370.
From this simple observation, we conclude that when there is sym- metry between the lessor and the lessee—same tax rates, costs, and so on— leasing is a zero-sum gume.2 If the lease is attractive to the lessee, the lease is unattractive to the lessor, and vice versa. However, conditions often are such that leasing can be of benefit to both parties. This situation arises because of differences in tax rates, estimated residual values, or the ability to bear msidual value risk. We will explore this issue in detail in a later section.
354 Understanding Healthcare Finance Management
SELF-TEST QUESTIONS
SELF-TEST QUESTION
1. What is lease analysis symmetry? 2. What impact does this symmetry have on the economic viability f
leasing?
Setting the Lease Payment
In the preceding sections, we evaluated the lease assuming that the lease payments had already been specified. However, as a general rule (especially in large leases), the parties will work out the terms of the lease, includin the size of the lease payments. In situations where the lease terms are not negotiable (which is often the case for small leases), the lessor must still go through the same type of analysis, setting terms that provide a target rate of return and then offering these terms to the potential lessee on a take-it-or- leave-it basis.
Competition in the leasing industry will force lessors to build market- related returns into their lease payment schedules. For an illustration, sup- pose Medicomp—after examining other alternative investment opportuni- ties—decides that the 5.4 percent return on the Nashville Radiology Group lease is too low and that the lease should provide an after-tax return of 6 percent. What lease payment schedule would provide this return?
To answer this question, note again that Exhibit 8.4 contains the les- sor’s cash flow analysis. If the basic analysis is done on a spreadsheet, it is easy to change the lease payment until the lease’s NPV = $0 at a 6 percent dis- count rate or, equivalendy, until its IRR = 6 percent. We did this with our spreadsheet lease evaluation model, and we found that the lessor must set the lease payment at $57,622 to obtain an expected after-tax rate of return of 6 percent. However, if this lease payment is not consistent with market rates, the Group may be able to strike a better deal with another lessor.
1. How do lessors set the lease payment amount?
□Leveraged Leases On the web at: ache.org/books/
UHFM7
In the early days of lease transactions, only two parties were involved: (1) the lessor, who put up the front money, and (2) the lessee, who used the asset. In recent years, however, a new type of lease—the leveraged lease—has come into widespread use. (In financial parlance, the term leverage means the use of debt financing.) Under a leveraged lease, the lessor arranges to borrow part of the required funds, generally giving the lender a lien on the property
Ziin/’s for leveraged leases, the lessor must have a minimum 20 percent
Chapter 8: Lease Financing
d is 80 percent of the purchase price.) In a leveraged lease, the lessor still receives the tax benefits associated th depreciation. However, the lessor now has a riskier position because
of its use of debt financing. Incidentally, whether or not a lease is leveraged not important to the lessee; from the lessee’s standpoint, the method of
inalyzing a proposed lease is unaffected by whether or not the lessor borrows part of the required capital.
The analysis in Exhibit 8.4 can be easily modified if the lessor borrows part of the required $200,000, making the transaction a leveraged lease. First we would add a set of lines to Exhibit 8.4 to show the financing cash flows. The interest component would represent another tax deduction, while the loan repayment would constitute an additional cash outlay. The “initial cost” would be reduced by the amount of the loan. With these changes made, a new NPV and IRR can be calculated and used to evaluate whether rhe lease would be a good investment.
For an illustration of this concept, assume that Medicomp can bor- row $100,000 of the $200,000 purchase price at a rate of 9 percent on a four-year, simple interest loan. Exhibit 8.5 contains the lessor’s leveraged lease analysis. Line 1 shows the unleveraged lease cash flows from Exhibit 8.4, while the leveraging cash flows are shown in lines 2 through 5. The net cash flows to Medicomp are shown in line 6. The NPV of the leveraged lease is $815, which is also the NPV of the unleveraged lease. In this situation, leveraging had no impact on the lessor’s per lease NPV. This result occurred because the cost of the loan to the lessor—5.4 percent after taxes—equals the discount rate, so the leveraging cash flows are netted out on a present value basis.
Note, though, that the lessor has a net investment of only $67,300 in the leveraged lease compared to a net investment of $167,300 in the unlev- eraged lease. Therefore, the lessor has the opportunity to invest in a total of N67,300 / $67,300 = 2.5 identical leveraged leases for the same $167,300 investment required to finance a single unleveraged lease, producing a total net present value of 2.5 x $815 = $2,038. The effect of leverage on the les- sor’s return is also reflected in the leveraged lease’s IRR. The IRR of the lev- eraged lease is 9.1 percent, which is substantially higher than the 5.6 percent '!fter-tax return on the unleveraged lease.
Leveraged leases can provide lessors with higher expected rates of return (IRRs) and higher NPVs per dollar of invested capital than unlever- aged leases. However, such leases are also riskier for the same reason that any lU ci aged investment is riskier. Sophisticated lessors use simulations similar to ‘'10se described in Chapter 12 to assess the riskiness associated with leveraged
356 Understanding Healthcare Finance Management
EXHIBIT 8.5 Leveraged Year 0 Yeari Year 2 Year 3 Year 4
Lease Analysis ~ - I. Unleveraged cash flow ($167,300) $48,700 $58,300 $47,900 $ 35,2oo 2. Loan amount 100,000 3. Interest (9,000) (9,000) (9,000) (9,000) 4. Interest tax savings 3,600 3,600 3,600 3,6oo 5. Principal repayment (100,000
)6. Net cash flow ($ 67,300) $43,300 $52,900 $42,500 ($70,200 )
NPV = $8i5. IRR = 9.I%.
leases. Then, given the apparent riskiness of the lease investment, the lessor can decide whether the returns built into the contract are sufficient to com- pensate for the risks involved.
SELF-TEST QUESTIONS 1. What is a leveraged lease?
2. How does leveraging affect the lessee’s analysis? 3. What is the usual impact of lease leveraging on the lessor’s
expected rate of return and risk?
Motivations for Leasing
We noted earlier that leasing is a zero-sum game unless there are lease analy- sis differentials between the lessee and the lessor. In this section, we discuss some of the differentials that motivate lease agreements.
Tax Differentials Many leases are driven by tax differentials. Historically, the typical tax asym- metry arose between highly taxed lessors and lessees with low tax rates. These low tax rates may be the result of low profitability or tax shields (primarily depreciation) that are sufficient to reduce taxable income to a small amount, even to zero. In such situations, the lessor can take the leased asset’s deprecia- tion tax benefits and then share this value with the lessee. Many other pos- sible tax motivations exist, including tax differentials between not-for-profit providers and investor-owned lessors, as well as the alternative minimum tax.
The alternative minimum tax (AMT), which roughly amounts to 24 percent of profits as reported to shareholders, is designed to force profit- able firms to pay at least some taxes. The AMT was instituted because the use of accelerated depreciation for tax purposes, along with other tax shelters,
flowed many businesses that report significant income to stockholders to pay |jftle or no federal income taxes.
Firms exposed to heavy tax liabilities under the AMT naturally seek ways to reduce reported income. Leasing can be beneficial because firms can use a relatively short period for the lease and consequently have a high annual payment, resulting in lower reported profits and a lower AMT liability. Note that the lease payments do not have to qualify as a deductible expense for regular tax purposes; all they need to do is reduce reported income shown on a firm’s income statement.
Lessors have designed spreadsheet models to deal with AMT consider- ations, and they are generating a substantial amount of leasing business as a direct result of the AMT. Thus, one of the important motivations for leasing is tax differential.
Ability to Bear Obsolescence (Residual Value) Risk Leasing is an attractive financing alternative for many high-tech items that are
subject to rapid and unpredictable technological obsolescence. For example, assume that a small, rural hospital wants to acquire an MRI device. If it buys the MRI equipment, it is exposed to the risk of technological obsolescence. In a relatively short time, some new technology might be developed that makes the current system almost worthless, and this large economic deprecia- tion can create a severe financial burden on the hospital. Because it does not use much equipment of this nature, the hospital would bear a great deal of risk if it buys the MRI device.
Conversely, a lessor that specializes in state-of-the-art medical equip- ment might be exposed to significantly less risk. By purchasing and then leasing many different high-tech items, the lessor benefits from portfolio diversifica- tion; over time, some items will lose more value than the lessor expected, but these losses will be offset by other items that retain more value than expected. Also, lessors are especially familiar with the markets for used medical equip- ment, so they can both estimate residual values better and negotiate better prices when the asset is resold than can a hospital. Because the lessor is better able to bear residual value risk than the hospital, the lessor can charge a pre- mium for bearing this risk that is less than the premium inherent in ownership.
Some lessors also offer programs that guarantee that the leased asset will be modified as necessary to keep it abreast of technological advance- ments. For an increased rental fee, lessors will provide upgrades to keep the leased equipment current regardless of the cost. To the extent that lessors are better able to forecast such upgrades; negotiate better terms from manu- facturers; and, by greater diversification, control the risks involved with such upgrades, it may be cheaper for businesses to obtain state-of-the-art equip- ment by leasing than by buying.
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Ability to Bear Utilization Risk As we discussed earlier in the chapter, per procedure (per use) leases are gain ing popularity among healthcare providers. In this type of lease, instead of fixed annual or monthly payment, the lessor charges the lessee a fixed amount for each procedure performed (each use of the asset). For example, the lessor may charge the hospital $300 for every scan performed using a leased MR] device, or it may charge $400 per scan for the first 50 scans in each month and $200 for each scan above 50. Because the hospital’s MRI revenues depend on the amount of utilization, and because the per procedure lease changes the hospital’s costs for the MRI from a fixed payment to a variable payment, the hospital’s risk is reduced.
However, the conversion of the payment to the lessor from a fixed amount to an uncertain stream increases the lessor’s risk. In essence, the les- sor is now bearing the utilization (operating) risk of the MRI. Although the passing of risk often produces no net benefit, a per procedure lease can be beneficial to both parties if the lessor is better able than the lessee to bear the utilization risk. As we discussed earlier, if the lessor has written a large number of per procedure leases, some of the leases will be more profitable than expected and some will be less profitable than expected, but if the les- sor’s expectations are unbiased, the aggregate return on all the leases will be close to that expected.
Ability to Bear Project Life Risk Leasing can also be attractive when a business is uncertain about how long an asset will be needed. Consider the following example. Hospitals sometimes offer services that are dependent on a single staff member—for example, a physician who does liver transplants. To support the physician’s practice, the hospital might have to invest millions of dollars in equipment that can be used only for this procedure. The hospital will charge for the use of the equipment, and if things go as expected, the investment will be profitable. However, if the physician dies or leaves the hospital staff, and if no other qualified physician can be recruited to fill the void, the project must be terminated and the equipment becomes useless to the hospital. A lease with a cancellation clause would permit the hospital to simply return the equip- ment to the lessor. The lessor would charge a premium for the cancellation clause because such clauses increase the riskiness of the lease to the lessor. The increased lease cost would lower the expected profitability of the project, but it would provide the hospital with an option to abandon the equipment, and such an option can have a value that exceeds the incremental cost of the cancellation clause. The leasing company would be willing to write this option because it is in a better position to remarket the equipment—either by writing another lease or by selling it outright.
Chapter 8: Lease Financing 359
Maintenance Services Some businesses find leasing attractive because the lessor is able to pro- vide better or less expensive maintenance services (or both). For example, ^EDTRANSPORT, Inc., a for-profit ambulance and medical transfer service, leased 25 ambulances and transfer vans. The lease agreement, with a lessor that specializes in purchasing, maintaining, and then reselling automobiles and trucks, permitted the replacement of an aging fleet that JJEDTRANSPORT had built up over several years. “We are pretty good at providing emergency services and moving sick people from one facility to another, but we aren’t very good at maintaining an automotive fleet,” said MEDTRANSPORT’S CEO.
Lower Information Costs Leasing may be financially attractive for smaller businesses that have limited access to debt markets. For example, a small, recently formed physician group practice may need to finance one or more diagnostic devices, such as an electrocardiogram machine. The group has no credit history, so it would be relatively difficult, and hence costly, for a bank to assess the group’s credit risk. Some banks might think the loan is not even worth the effort. Others might be willing to make the loan, but only after building the high cost of credit assessment into the cost of the loan. On the other hand, some les- sors specialize in leasing to group practices, so their analysts have assessed the financial worthiness of hundreds, or even thousands, of group practices. Thus, it would be relatively easy for them to make the credit judgment, and hence they might be more willing than conventional lenders to provide the financing and charge lower rates.
Lower Risk in Bankruptcy Finally, for firms that are poor credit risks, leasing may be less expensive than buying. As discussed earlier, in the event of financial distress leading to reorganization or liquidation, lessors generally have more secure claims than do lenders. Thus, lessors may be willing to write leases to firms with poor financial characteristics that are less costly than loans offered by lenders, if such loans are even available.
Credit Availability It is sometimes argued that businesses can obtain more money, and for longer periods, under a lease arrangement than under a loan secured by a specific piece of property. Also, because some leases do not appear on the balance sheet, lease financing has been said to give the business a stronger appear- ance in a superficial credit analysis; thus, it permits the firm to use more, or cheaper, debt financing than would otherwise be possible.
As discussed previously, there may be some truth to these clai for smaller businesses or for businesses facing financial distress. How because businesses are required to capitalize financial leases and report the ’ on their balance sheets and to disclose operating leases in the notes to th financial statements, this point is of questionable validity for any financially sound business large enough to have audited financial statements. Further more, at some point in the near future all leases will be reported directly on the balance sheet.
Liquidity Preservation Most of the promotional material prepared by lessors states that the big- gest advantage of leasing is that it preserves liquidity—that is, by leasing a business avoids using cash resources to make the initial outlay required to purchase the asset. Although the statement is true, it ignores the fact that the lessee becomes contractually obligated to make a series of payments to the lessor. The alternative to leasing—borrowing and buying—also enables a business to avoid using current cash to buy the asset because the loan amount is used to make the purchase; hence, it also preserves liquidity. Under the borrow-and-buy scenario, the potential lessee again is obligated to make a series of payments, but this time to the lender. When one carefully considers the situation, it is obvious that leasing is advantageous only when it costs less than borrowing and buying.
There arc other reasons that might motivate firms to lease an asset rather than buy it. Often, these reasons are difficult to quantify, so they can- not be easily incorporated into a numerical analysis. Nevertheless, a sound lease analysis must begin with a quantitative analysis, and then qualitative factors can be considered before making the final lease-or-buy decision.
SELF-TEST QUESTIONS 1. What are some economic factors that motivate leasing—that is,
what asymmetries might exist that make leasing beneficial to both lessors and lessees?
2. Would it ever make sense to lease an asset that has a negative NAL when evaluated by a conventional lease analysis? Explain your answer.
3. Does leasing lead to increased credit availability? 4. What is your reaction to this statement: “Leasing is preferable to
buying because it preserves the business’s liquidity”?
Chapter Key Concepts In this chapter, we discuss leasing decisions from the standpoints of the lessee and lessor. Here are its key concepts:
• Lease agreements often are categorized as operating leases or financial leases.
• The IRS has specific guidelines that apply to lease arrangements. A lease that meets these guidelines is called a guideline, or tax- oriented, lease because the IRS permits the lessee to deduct the lease payments. A lease that does not meet IRS guidelines is called a non-guideline, or non-tax-oriented, lease. In such leases, ownership resides with the lessee rather than with the lessor.
• FASB Statement 13 spells out the conditions under which a lease must be capitalized (shown directly on the lessee’s balance sheet), as opposed to being shown only in the notes of the financial statements. Generally, leases that run for a period equal to or greater than 75 percent of the asset’s life must be capitalized. Note, however, that changes to the accounting rules are likely to require that almost all leases be capitalized (shown directiy on the balance sheet) by 2017.
• The lessee’s analysis consists of a comparison of the costs and benefits associated with leasing the asset and the costs and benefits associated with owning the asset. Two analytical techniques can be used: (1) the dollar-cost (NAL) method and (2) the percentage-cost (IRR) method.
• One of the key issues in the lessee’s analysis is the appropriate discount rate. Because the cash flows in a lease analysis are known with relative certainty, the appropriate discount rate is the lessee’s after-tax cost of debt. A higher discount rate may be used on the residual value if it is substantially riskier than the other flows.
• In a lessor’s analysis, the return on a lease investment is compared with the return available on alternative investments of similar risk.
• In a leveraged lease, the lessor borrows part of the funds required to buy the asset. Generally, the asset is pledged as collateral for the loan.
• Leasing is motivated by differentials between lessees and lessors. Some of the more common reasons for leasing are (1) tax rate differentials, (2) alternative minimum taxes, (3) residual risk bearing, and (4) lack of access to conventional debt markets.
(continued)
362 Understanding Healthcare Finance Management
(continued from previous page)
This chapter concludes our discussion of lease financing. FUr thermore, it wraps up the coverage of Part III (capital acquisition) in Chapter 9, we begin our coverage of cost of capital and capital structure decisions.
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
• A chapter model that shows how to perform many of the calculations described in the chapter
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and tests your
ability to perform the calculations in preparation for a case
These resources can be accessed on the book’s companion website at ache. org/books/UHFM7.
Selected Case
One case in Cases in Healthcare Finance, 5th edition, is applicable to this chapter:
• Case 17: Seattle Cancer Center, which focuses on leasing decisions from the perspectives of both the lessee and lessor.
Selected Bibliography
Bernstein, C. 2006. “Is Your Leasing Arrangement Paying Off?” Healthcare Finan-
cial Management 60 (8): 46-48, 50.
Cleverley, W. O., and S. J. Baserman. 2005. “Patterns of Financing for the Largest
Hospital Systems in the United States.” Journal of Healthcare Management
50 (6): 361-65.
Conbeer, G. P. 2007. “Making the Right Long-Term Prescription for Medical
Equipment Financing.” Healthcare Financial Management 61 (6): 88-93.
McCue, M- J- 2007. “Factors Associated with Lease Financing in the Hospital Indus- try.” Journal of Health Care Finance 33 (3): 72-84.
McIntire, M., and D. J. Waldron. 2006. “Funding Technology: Evaluating and Exercising the Leasing Option.” Healthcare Financial Management 60 (11): 92-98, 100.
Tolbert, S. H., and C. P. Wood. 2007. “Leasing vs. Owning a Medical Office: An Analytical Model.” Journal of Health Care Finance 34 (2): 71-80.
Ung, and J. Zeinfeld. 2011. “How to Optimize an Equipment Leasing Pro- gram.” Healthcare Financial Management 65 (4): 92-96.
Valletta, R., and B. Huggins. 2010. “Emerging Accounting Trends: Accounting for Leases.” Healthcare Financial Management 64 (12): 36-39.
Selected Websites
• To obtain information about leasing from the Equipment Leasing and Finance Association (an association of equipment lessors), see www. elfaonline.org.
• For one example of a leasing company that has a large medical equipment component, see www.acgcapital.com.
• The following webpage contains a glossary of leasing terminology: www.equipmentfinanceadvantage.org/efl 01/ glossary, cfm.
• Although not direcdy related to healthcare equipment leasing, the following website contains a wealth of information on automobile leases: www.leasesource.com.
Notes
1. In fact, General Electric has a subsidiary, GE Capital Corporation, which is one of the largest lessors in the world. The subsidiary was originally set up to finance consumers’ purchases of GE’s durable goods, such as refrigerators and washing machines, but it has become a major player in the commercial loan and leasing markets.
2. The zero-sum-game feature of leasing can be useful in debugging lease analysis models. Whenever we build a new spreadsheet model that contains both the lessee’s and the lessor’s analyses, we test it by trying symmetrical input values for the lessee and lessor. If the lessee’s NAL and lessor’s NPV are not equal, but opposite in sign, there is something wrong with the model!
364 Understanding Healthcare Finance Management
Integrative Application
The Problem
Brooklyn Family Medicine, a for-profit group practice, has decided to acquire a new top-of-the-line electrocardiogram (ECG) machine. One alternative would be to purchase the equipment outright for $40,000. If purchased, the practice could borrow the amount needed from a local bank at a 10 percent annual interest rate Also, if purchased, the practice would have to sign a maintenance contract with a vendor that would cost $1,000 annually, payable at year end. Alternatively, the practice could lease the machine on a four-year guideline lease with a payment of $10,000, payable at the beginning of each year. The lease includes maintenance. The ECG machine falls into the MACRS three-year class (allowances are 33,45, i5> and 7 percent in Years 1 through 4, respectively), the machine’s estimated resid- ual value is $10,000, and the practice’s federal-plus-state tax rate is 40 percent. In addition, the CEO of Brooklyn Family Medicine believes that the recent election of a new state governor could result in a reduction of the practice’s tax rate from 40 percent to 34 percent, but she doesn’t know how this will affect the analysis. The decision at hand is whether to buy or to lease the equipment.
The Analysis
Yearo Year 1 Year 2 Year 3 Year 4
1. Cost of Owning (Borrowing and Buying) 1. Net purchase price ($40,000) 2. Maintenance cost ($ 1,000) ($ 1,000) ($ 1,000) ($ 1,000) 3. Maintenance tax savings 400 400 400 400 4. Depreciation tax savings 5,280 7,200 2,400 $1,120 5. Residual value 10,000 6. Residual value tax (4,000) 7. Net cash flow ($40,000) $ 4,680 $ 6,600 $18,000 $ 6,520 8. PV cost of owning
@ 6% = ($23,035)
II. Cost of Leasing
9. Lease payment ($10,000)($10,000) ($10,000) ($10,000) 10. Tax savings 4,000 4,000 4,000 4,000 11. Net cash flow C h 0 0 0($ 6,000) ($ 6,000) ($ 6,000) 0 12. PV cost of leasing
© 6% = ($22,038)
III. Cost Comparison
13. Net advantage to leasing (NAL) = PV cost of leasing - PV cost of owning = - 22,038 - (-23,035) = $997.
Chapter 8: Lease Financing 365
If the tax rate falls to 34 percent, then the PV of the cost of leasing increases to $24,048* the of the cost of owning increases to $25,128, and the NAL ^creases to $1,080. Both the cost of leasing and the cost of owning increase because the tax shield is smaller when the tax rate falls. However, the reduction in the tax shield for leasing is less than the reduction for owning, so the NAL increases.
The Decision
With a positive NAL, leasing is the lower cost-financing alternative. Furthermore, if the tax rate falls as the CEO predicts, this makes leasing even more attrac- tive. Therefore, the CEO of Brooklyn Family Medicine decided to lease the ECG machine. ■
r PART COST OF CAPITAL AND CAPITAL
STRUCTURE
In Part III, you learn that businesses use two primary forms of capital(financing): debt and equity. You also learn that these two types of capitalhave different characteristics—that is, they present businesses with financ- ing choices that bring different risks and potential rewards.
In Part IV, we discuss two important topics related to the financing choices made by businesses. The first, cost of capital (covered in Chapter 9), involves measuring the costs associated with a business’s financing. Provid- ers of business capital expect to earn a return on the funds they provide; this expectation means that businesses incur costs to use capital. With an estimate of these costs, managers can make better decisions regarding capital alloca- tion (i.e., which assets should be acquired).
The second topic, capital structure, is covered in Chapter 10. Busi- nesses have a choice regarding how much debt versus equity capital should be used to finance the business’s assets. This choice affects the riskiness of the business, the cost of its financing, and hence its potential profitability. Chapter 10 discusses the factors that affect this decision.
CHAPTER
9COST OF CAPITAL Learning Objectives Alter studying this chapter, readers should be able to
• describe the general process for estimating a business’s corporate (overall) cost of capital,
• estimate the component costs of debt and equity as well as the corporate cost of capital for any healthcare business, including not- for-profit and small businesses,
• describe the uncertainties inherent in the cost-of-capital estimation process, and
• explain the economic meaning of the corporate cost of capital and how it is used in capital investment decisions.
Introduction
The cost of capital is an extremely important concept in healthcare finan- cial management. All businesses—whether large, small, investor-owned, or not-for-profit—have to raise funds to buy the assets required to meet their strategic objectives. Hospitals, nursing homes, clinics, group practices, and so on need buildings, equipment, and inventories to provide services. The funds to acquire these assets come in many shapes and forms, including contribu- tions; profit retention; equity sales to stockholders; and debt capital supplied by creditors, such as banks, bondholders, lessors, and suppliers. Most of the capital raised by organizations has a cost that is either explicit (such as the interest payments on debt) or implicit (such as the opportunity cost associ- ated with equity capital). Because many business decisions require the cost of capital as an input, managers must understand the cost-of-capital concept and know how to both estimate the costs of capital for their firms and properly apply the estimate when making capital investment decisions.
Overview of the Cost-of-Capital Estimation Process
The ultimate goal of the cost-of-capital estimation process is to estimate the business’s corporate cost of capital, which represents the blended, or average,
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370 Understanding Healthcare Finance Management
cost of a business’s financing mix. This cost, in turn, is used as the rate of return on the business’s capital investment opportunities. For • ° pie, assume Bayside Memorial Hospital, a not-for-profit integrated deliv system, has a corporate cost of capital estimate of 10.2 percent. If a new MRJ (magnetic resonance imaging) investment is expected to return at least l(j 2 percent, it is financially attractive to the business. If the MRI is expected return less than 10.2 percent, the investment will have an adverse effect on the business’s financial soundness. Here, we assume that the project under consideration has average risk—that is, the same risk as the overall business As we discuss later in this chapter and in Chapter 12, the corporate cost of capital must be adjusted to reflect project risk when it differs from the overall risk of the business.
The corporate cost of capital is a weighted average of the component (i.e., debt and equity) costs, adjusted for tax effects. After the component costs have been estimated, they are combined to form the corporate cost of capital. Thus, the first step in the cost-of-capital estimation process is to estimate both the cost of debt and the cost of equity. However, before the mechanics of cost estimation are discussed, some other issues regarding the estimation process must be addressed.
What Capital Components Should Be Included? The first task in estimating a business’s corporate cost of capital is to deter- mine which sources of capital, shown on the right side of the business’s balance sheet, should be included in the estimate. In general, the corporate cost of capital focuses on the cost of permanent capital (long-term capital) because these sources are used to finance capital asset acquisitions. Thus, for most firms, the capital components included in the corporate-cost-of-capital estimate are equity and long-term debt. Typically, short-term debt is used only as temporary financing to support seasonal or cyclical fluctuations in volume, and hence assets, so it is not included in the cost-of-capital estimate. However, if a firm does use short-term debt as part of its permanent financing mix, it should be included in the cost-of-capital estimate. (We discuss why short-term debt is not well suited for financing permanent assets in Chapter 10.)
Do Taxes Need to Be Considered? In developing component costs, investor-owned businesses face the issue of tax effects. Should the component costs be estimated on a before- or after- tax basis? As we discuss in Chapter 10, the use of debt financing creates a tax benefit because interest expense is tax deductible, while the use of equity financing has no impact on taxes. This tax benefit can be handled in sev- eral ways when working with capital costs, but the most common way is to include it in the cost-of-capital estimate. Thus, the tax benefit associated with
debt financing will be recognized in the component-cost-of-debt estimate, resulting in an after-tax cost of debt.
Should the Focus Be on Historical or Marginal Costs? 7wo different sets of capital costs can be measured: (1) historical, or embed-
ded costs, which reflect the cost of funds raised in the past, and (2) new, or marginal, costs, which measure the cost of funds to be raised in the future. Historical costs are important for many purposes. For example, payers that reimburse on a cost basis are concerned with embedded costs, as are taxing authorities. However, the primary purpose in developing a business’s corpo- rate cost of capital is to use it in making capital investment decisions, which involve future asset acquisitions and future financing. For these purposes, the relevant costs are the marginal costs of new funds to be raised during some future planning period—say, the coming year—and not the cost of funds raised in the past.
1. What is the basic concept of the corporate cost of capital? 2. What financing sources are typically included in a firm’s cost-of-
capital estimate? 3. Should the component costs be estimated on a before-tax basis or
an after-tax basis? 4. Should the component-cost estimates reflect historical costs or
marginal costs?
SELF-TEST QUESTIONS
Estimating the Cost of Debt
Although the cost-of-capital estimation process is the same, some of the details of component-cost estimation differ depending on the type of busi- ness. We begin our discussion by focusing on large businesses—primarily publicly traded for-profit businesses. Along the way, we point out some of the differences in cost estimation between investor-owned and not-for-profit businesses. Then, later in the chapter, we will discuss some unique features of cost-of-capital estimation in small businesses.
It is unlikely that a business’s managers will know at the start of a plan- ning period the exact types and amounts of debt the firm will issue in the future; the type of debt used will depend on the specific assets to be financed and on market conditions as they develop over time. However, they do know what types of debt the business usually issues. For example, Bayside typically uses bank debt to raise short-term funds to finance seasonal or cyclical work- ing capital needs, and it uses 30-year tax-exempt (municipal) bonds to raise
On the web at: ache.org/books/ UHFMy
Understanding Healthcare Finance Management
372
How the Choice of Issuing Authority Affects Hospital Debt
Financing Costs Hospitals need to know how their choice of bond- issuing authority affects debt financing costs. States vary in the vehicles that not for-profit orga- nizations can use to issue tax-exempt debt: (l) a single statewide authority, (2) local authorities, or (3) local and statewide authority. In a 2013 study, Caryl Carpenter and Patrick Bernet found that, all other things being equal, bonds issued by state- wide authorities have lower yields than bonds issued by local authorities. Investors recognize that statewide authorities have greater oversight of not-for-profit hospitals and are less likely to issue bonds for highly risky institutions. In addi- tion, investors are more familiar with the policies and procedures of large, statewide authorities, and that transparency may lead to a lower cost of capital. Although lower yields may be offset by higher issuance costs for statewide authorities, the services provided in exchange for the higher issuance costs —including enhanced information and protection for bondholders—may benefit both the investors and the issuing hospitals.
Source: Carpenter and Bernet (2013).
long-term debt capital. Because Bayside does not use short-term debt to finance permanent assets, its managers include only long-term debt in their corporate - cost-of-capital estimate, and they assume that this debt will consist solely of 30-year tax-exempt bonds.
Suppose that Bayside’s managers arc developing the system’s corporate-cost- of-capital estimate for the coming year How should they estimate the cost of debt"' Most managers of large businesses would begin by discussing current and prospec- tive interest rates with their firms’ invest- ment bankers, which are institutions that help businesses obtain financing. Assume that the municipal bond underwriter at Suncoast Securities, Inc., Bayside’s invest- ment banker, stated that a new 30-year tax-exempt healthcare issue would require semiannual interest payments of $30.50 ($61 annually) for each $1,000 par value bond issued. Thus, municipal bond inves- tors currently require a $61/$ 1,000 = 0.061 = 6.1% return on Bayside’s 30-year bonds. This rate of return required by investors (the interest rate) establishes the cost of debt to Bayside.
The true cost of debt to Bayside would be somewhat higher than 6.1 percent because the system must incur issuance, or flotation, costs (such as legal, accounting, and marketing expenses) to sell the bonds. However, flo- tation costs are often small, especially on debt financing, so their impact on the cost of debt estimate is inconsequential, especially when the uncertainty inherent in the cost of capital estimation process is considered. Therefore, as we will discuss later in the chapter, it is common practice to ignore flota- tion costs when estimating a business’s cost of capital. Bayside follows this practice, so its managers would estimate the component cost of debt as 6.1 percent:
Tax-exempt component cost of debt = R(Rd) = 6.1%.
If Bayside’s current outstanding debt were actively traded, the cur- rent yield to maturity (YTM) on this debt could be used to estimate the cost of new debt. For example, assume that Bayside has an actively traded
Chapter 9: Cost of Capital 373
outstanding issue that has a 7 percent coupon rate with semiannual pay- ments, currently sells for $1,114.69, and has 25 years remaining to maturity. Using a spreadsheet, we determine that the semiannual YTM on this bond is 3.05 percent:
A B C D
1
2 50 Nper Number of periods
3 $(1,114.69) Pv Present value (bond price)
4 $35.00 Pmt Payment (coupon amount)
5 $1,000.00 Fv Future value (principal)
6
7
8 3.05% =RATE(A2,A4,A3,A5) (entered into cell A8)
9
10
Because this rate is semiannual, the resulting solution, 3.05 percent, must be multiplied by two to get the annual YTM, resulting in a cost of debt estimate of 6.1 percent.1
Using the YTM on an outstanding issue to estimate the cost of new debt works reasonably well when the remaining life of the old issue approxi- mates the anticipated maturity of the new issue. If this is not the case, yield curve differentials may cause the estimate to be biased. For example, if the yield curve were upward sloping in the 25- to 30-year range, the YTM on a 25-year outstanding issue would understate the actual cost of a new 30-year issue. If the understatement is material, an adjustment can be made on the basis of the current yield curve on Treasury securities. For example, suppose the yield on 25-year T-bonds is 5.5 percent and the yield on 30-year T-bonds is 5.7 percent, a difference of 0.2 percentage points. The 6.1 percent esti- mate for Bayside’s cost of debt based on outstanding 25-year bonds could be increased to 6.3 percent to account for yield curve differentials.
A taxable healthcare provider would use one or more of the techniques described here to estimate its before-tax cost of debt. However, the tax benefits of interest payments must then be incorporated into the estimate. For a for- profit business, the after-tax component cost of debt is calculated as follows:
Key Equation 9.1: After-Tax Cost of Debt After-tax cost of debt = R(Rd) x (1 - T).
Here, R(Rd) is the before-tax cost of debt (required interest rate) and T is the tax rate.
For example, consider Ann Arbor Health Care, Inc., a publicly traded for-profit business. The firm’s investment bankers indicate that a new 30-year
374 Understanding Healthcare Finance Management
corporate bond issue that has Ann Arbor’s BBB rating would require an interest rate of 10 percent. Because the firm’s federal-plus-state tax rate is 49 percent, its after-tax cost of debt estimate is lowered to 6 percent:
After-tax cost of debt = R(Rd) x (1 - T)
= 10% x (1 - 0.40) = 10% x 0.60 = 6%.
By reducing Ann Arbor’s component cost of debt from 10 percent to 6 percent, the cost-of-debt estimate has incorporated the benefit associated with interest payment tax deductibility.
In general, the effective cost of debt is roughly comparable between investor-owned and not-for-profit firms of similar risk. Investor-owned firms have the benefit of tax deductibility of interest payments, while not-for-profit firms have the benefit of being able to issue lower-cost tax-exempt debt. Under normal economic conditions, these two benefits are roughly the same, resulting in a similar cost of debt. In our illustrations, the effective cost of debt is 6.0 percent for Ann Arbor, an investor-owned firm, and 6.1 percent for Bayside, a similar not-for-profit business.
SELF-TEST QUESTIONS 1. What are some methods used to estimate a business’s cost of debt?
2. For investor-owned firms, how is the before-tax cost of debt converted to an after-tax cost?
3. Does the effective cost of debt differ materially between businesses that are similar in all respects except ownership?
Estimating the Cost of Equity to Large Investor-Owned Businesses
Large investor-owned businesses (corporations) raise equity capital by sell- ing new common stock and by retaining earnings for use by the firm rather than paying them out as dividends to shareholders.2 Not-for-profit businesses raise equity capital through contributions and grants and by generating an excess of revenues over expenses, none of which can be paid out as dividends. This section describes how to estimate the cost of equity capital for large investor-owned businesses. The next major section focuses on large not-for- profit businesses, while the cost-of-equity estimation for small businesses is discussed later in the chapter.
The cost of debt is based on the return (interest rate) that investors require on debt securities, and the cost of equity to investor-owned businesses can be defined similarly: It is the rate of return that investors require on the
Chapter 9: Cost of Capital 375
firm’s common stock. At first glance, equity raised through retained earn- ings may appear to be a costless source of capital to investor-owned busi- nesses. After all, dividend payments must be paid at some point in time on any new shares of stock that are issued, but no such payments are required on funds obtained by retaining earnings. The reason that a cost of capital must be assigned to all forms of equity financing involves the opportunity cost principle. An investor-owned firm’s net income literally belongs to its common stockholders. Employees are compensated by wages, suppliers are compensated by cash payments for supplies, bondholders are compensated by interest payments, governments are compensated by tax payments, and so on. The residual earnings of a firm—its net income—belong to the stockholders and “pay the rent” on stockholder-supplied capital.
The firm can either pay out earnings in the form of dividends or retain earnings for reinvestment in the business. If it retains part of the earnings, it incurs an opportunity cost; stockholders could have received those earnings as dividends and then invested this money in stocks, bonds, real estate, com- modity futures, or any other investment. Thus, the firm should earn on its retained earnings at least as much as its stockholders can earn on alternative investments of similar risk. If the firm cannot earn as much as stockholders can in similar risk investments, the firm’s net income should be paid out as dividends rather than retained for reinvestment in the business. What rate of return can stockholders expect to earn on other investments of equivalent risk? The answer is R(R ), the required rate of return on equity (ROE). Inves- tors can earn this return either by buying more shares of the firm in question or by buying the stock of similar businesses.
Whereas debt is a contractual obligation with an easily estimated cost, the cost of equity is not nearly as easy to estimate. Large, investor-owned businesses use three primary methods in the estimation process: (1) the Capi- tal Asset Pricing Model (CAPM), (2) the discounted cash flow (DCF) model, and (3) the debt-cost-plus-risk-premium method. These methods should not be regarded as mutually exclusive, for no single approach dominates the estimation process. In practice, all approaches should be used to estimate the cost of equity, and then the final value should be chosen on the basis of the managers’ confidence in the data at hand.
Capital Asset Pricing Model Approach The CAPM, which was first discussed in Chapter 5, is a widely accepted finance model that specifies the equilibrium risk-return relationship on com- mon stocks. Basically, the model assumes that investors consider only one risk factor when setting required rates of return: the volatility of returns on the stock relative to the volatility of returns on a well-diversified portfolio called the market portfolio., or just the market. The measure of risk in the CAPM
37* Understanding Healthcare Finance Management
is the stock’s market beta. The market, which is a large collection of stocks often proxied by the S&P 500 Index, has a beta of 1.0. A stock with a beta of 2.0 has twice the volatility of returns as the market, while a stock with a beta of 0.5 has half the volatility of returns as the market. Because relative volatility measures market risk, a low beta stock (which has a beta less than 1.0) is less risky than the market, while a high beta stock (which has a beta greater than 1.0) is more risky than the market.
Under the CAPM, the equation that relates risk to return is called the Security Market Line (SML):
Key Equation 9.2: Security Market Line of the Capital Asset Pricing Model
R(R) = RF + [R(RM) - RF] x b
= RF + (RPM x b).
Here,
• R(RC) = required rate of return on equity; • RF = risk-free rate; • R(RM) = required rate of return on the market; • b. = beta coefficient of the stock in question; • [R(RM) - RF)] = RPM = market risk premium, the premium above the
risk-free rate that investors require to buy a stock with average risk; and • (RPM) x b. = stock risk premium, the premium above the risk-free rate
that investors require to buy the stock in question.
Managers can calculate the required rate of return on a firm’s stock given estimates of the risk-free rate, RF; the beta of the firm’s stock, b.; and the required rate of return on the market, R(RM). This result, in turn, can be used as one estimate of the firm’s cost of equity.
Estimating the Risk-Free Rate The starting point for the CAPM cost-of-equity estimate is RF, the risk-free rate. Unfortunately, there is no unambiguous proxy for this rate. Treasury securities are essentially free of default risk, but long-term T-bonds will suf- fer capital losses if interest rates rise, and a portfolio invested in short-term T-bills will provide a volatile earnings stream because the rate paid on T-bills varies over time.
Chapter 9: Cost of Capital 377
Because we cannot, in practice, find a truly riskless rate on which to base the CAPM, what rate should we use? In past years, most analysts have used the rate on long-term Treasury bonds, traditionally defined as 30-year bonds. There are many reasons for favoring the T-bond rate, including the fact that T-bill rates are volatile because they are directly affected by actions taken by the Federal Reserve Board. Perhaps the most persuasive argument is that common stocks have traditionally been viewed as long-term investments, so stock returns should embody the long-term inflation expectations embod- ied in bonds, rather than the short-term inflation expectations embodied in bills. On this account, the cost of equity should be more highly correlated with T-bond rates than with T-bill rates.
However, recent events have shaken the position that the CAPM risk-free rate should be based on 30-year T-bonds. First, there is no doubt that some investors view common stocks not as long-term investments but rather as short-term trading vehicles. Until the mid-1960s, stock-fund managers bought and sold about 15 percent of their portfolios each year, which implies a holding period of about seven years. Since then, however, managers have been trading with ever increasing frequency, with turnover rates today at about 90 percent, which translates into a holding period of just over a year.
Second, in recent years the US Treasury has emphasized the use of shorter maturity debt. The Treasury even suspended the issue of 30-year bonds from 2001 to 2006. This action caused the Wall Street Journal to change its “benchmark” long-term interest rate from 30-year Treasuries to 10-year Treasuries. As a result, many analysts are now using the 10-year note as the basis for the CAPM risk-free rate. We are not going to agonize over the issue because typically there is little difference in the yields on the two securities. In fact, we will often “hedge our bet” by using the 20-year T-bond rate as the proxy for the CAPM risk-free rate. Still, we feel strongly that the risk-free rate should not be based on the T-bill rate, which is subject to many influences that are not related to stock returns.
Estimating the Market Risk Premium The market risk premium, RPM = [R(RM) - KF], can be estimated on the basis of historical returns or expected returns.
The most complete, accurate, and up-to-date historical returns study is published annually by Morningstar (previously by Ibbotson Associates). It examines market data over long periods (from 1926 to the present) to deter- mine the average annual rates of return and standard deviations of various classes of securities.3 By examining the spread between the historical rates of return on stocks and Treasury bonds, it is possible to obtain the historical
average risk premium of stocks over T-bonds. The data suggest that premium is about 6 to 7 percentage points when arithmetic average are used and about 4 to 5 percentage points when geometric average are used.
this risk returns returns
However, the basic returns data have large standard deviations, so one must use historical averages with caution. Also, in years such as 2000-2002 and 2008, bonds had higher returns than stocks, which would indicate a neg ative risk premium. In addition, when stock returns are abnormally high the average risk premium increases, while the opposite occurs when stock returns are abnormally low. This impact on the historical average is the opposite of what it should be, as low stock returns indicate an increasing risk premium and vice versa.
Finally, the choice of the beginning and ending periods can have a major impact on the calculated risk premiums. All of these considerations suggest that the historical average risk premium should be used with cau- tion, although in some situations it may be the only measure available. As one businessman muttered after listening to a professor give a lecture on the CAPM: “Beware of academics bearing gifts!”
The historical approach to risk premiums assumes that investors expect future results, on average, to equal past results. However, as we noted, the historical risk premium varies greatly depending on the period selected, and, in any event, investors today probably expect results in the future to be dif- ferent from those achieved many years ago, all of which are included and given equal weight in the historical returns data. The questionable assump- tion that future expectations are equal to past realizations—together with the sometimes nonsensical results obtained when calculating historical risk pre- miums—has led to the search for expected (forward-looking) risk premiums.
The most common approach to estimating expected market risk pre- miums uses the discounted cash flow (DCF) model to estimate the expected market rate of return, E(RM). Then, assuming market equilibrium, the expected rate of return is used as the proxy for the required rate of return, R(RM). Finally, RF is subtracted to obtain the estimate for the expected market risk premium. Many financial services firms publish forecasts of the expected rate of return on the market, and these values can be used as inputs into the CAPM.
Clearly, there is no good answer to the question of how to estimate the CAPM market risk premium. Still, it has to be done to use the CAPM method to estimate a firm’s cost of equity. It is our view that the risk pre- mium is driven primarily by equity investors’ attitudes toward risk, and there are good reasons to believe that investors are less risk averse today than they were 50 years ago. The advent of pension plans, Social Security, health and disability insurance, and dual-income families means that investors can take
oil more risk with their stock investments, which lowers the market risk premium.
The bottom line is that we favor a market risk premium of about 5 percentage points, but we would have a hard time arguing against someone using a premium anywhere in the range of roughly 4 to 6 percentage points. \Ve believe that investor risk aversion is relatively stable but not absolutely constant from year to year. When stock prices are relatively high, investors are less risk averse, so we use a smaller risk premium. Conversely, we use a larger premium (but still in the range) when stock prices are relatively low. There is no way to prove that a particular risk premium value is right or wrong, although we would be suspicious of an estimated premium that is much less than 4 percentage points or much greater than 6 percentage points.
The last parameter needed for a CAPM cost-of-equity estimate is the beta coefficient. Recall from Chapter 7 that a stock’s beta is a measure of its volatility relative to that of an average stock and that betas are generally estimated from the stock’s characteristic line, which is estimated by running a linear regression between past returns on the stock in question and past returns on some market index. We define betas developed in this manner as historical betas.
Estimating Beta Unfortunately, historical betas show how risky a stock was in the past, whereas
investors are interested in future risk. A given firm might have appeared safe in the past, but things may have changed and its future risk may be judged to be higher than its past risk, or vice versa. The hospital industry presents a good example. Prior to 1983, when the industry operated on a cost-plus basis, investor-owned hospitals were among the bluest of the blue chips. However, when prospective payment began, the industry became riskier. The increasing market power of managed care plans has further added to hospitals’ risk.
When we use a historical beta in a CAPM framework to measure the firm’s cost of equity, we are implicitly assuming that future risk is the same as past risk. This assumption would be troublesome for a hospital in 1983, but what about most firms in most years? As a general rule, is future risk suf- ficiently similar to past risk to warrant the use of historical betas in a CAPM framework? For individual firms, historical betas are often unstable, so past risk is often not a good predictor of future risk.
Because historical betas may not be good predictors of future risk, researchers have sought ways to improve them. This research has led to the development of two other types of betas: (1) adjusted betas and (2) funda- mental betas. Adjusted betas recognize that true betas tend to move toward 1.0 over time. Therefore, one can begin with a firm’s pure historical statistical
380 Understanding Healthcare Finance Management
beta; make an adjustment for the expected future movement toward 1 ft. •Vj d|)Q produce an adjusted beta that, on average, will be a better predictor of future beta than would the unadjusted historical beta.4
Finally, fundamental betas extend the adjustment process to includ such fundamental risk variables as the use of debt financing, sales volatility and the like. These betas are constantly adjusted to reflect changes in a firm’s operations and capital structure, whereas with historical betas, including adjusted ones, such changes might not be fully reflected until several years after the firm’s “true” beta has changed.
Adjusted betas are obviously heavily dependent on unadjusted histori- cal betas, and so are fundamental betas because they too use historical betas as the starting point. Therefore, the “regular” historical beta—calculated as the slope of the characteristic line—is important even if one goes on to develop a more exotic version. With this in mind, note that several different sets of data can be used to calculate historical betas, and the different data sets produce different results.
Here are some points to note:
• Betas can be based on historical periods of different lengths. For example, data for the past one, two, and three years and so on may be used. Most analysts who calculate betas today use five years of data, but this choice is arbitrary, and different lengths of time usually alter the calculated beta for a given firm significandy.5
• Returns may be calculated on holding periods of different lengths—a day, a week, a month, a quarter, a year, and so on. For example, if we decide to analyze data on the New York Stock Exchange (NYSE) stocks over a five-year period, we might obtain 52 x 5 = 260 weekly returns, or 1 x 5 = 5 annual returns. The set of returns on each stock, however large it turns out to be, would then be regressed on the corresponding market returns to obtain the stock’s beta. In statistical analysis, it is generally better to have more, rather than fewer, observations because using more observations generally leads to greater statistical confidence. Preferably, we would use weekly returns and, say, five years of data for a sample size of 260, or even daily returns for a larger sample size. However, the shorter the holding period, the more likely die data are to exhibit random “noise,” and the greater the number of years of data, the more likely the firm’s market risk will have changed. Thus, choosing the number of years of data and the length of the holding period involves a trade-off between a desire to have many observations versus a desire to have recent and consequently more relevant data.
• The value used to represent “the market” is also an important consideration and one that can have a significant effect on the calculated beta. Most beta calculators today use the NYSE Composite Index—which is based on more than 2,000 stocks, weighted by the value of each firm—but others use the S&P 500 Index or some other group, including the Dow Jones Wilshire 5000 Index (also called the Total Stock Market Index), which is based on approximately 4,100 stocks. In theory, the broader the index, the better the beta; indeed, the index should include returns on all risky assets, including stocks, bonds, leases, private businesses, real estate, and even “human capital.” As a practical matter, however, we cannot obtain accurate returns data on most types of assets, so measurement problems necessitate the use of stock indexes to measure market returns.
The bottom line is that one can calculate betas in many different ways, and, depending on the methods used, different betas and hence different cost-of-equity estimates will result. Where does this leave managers regard- ing the proper beta? The choice is a matter of judgment and data availability because there is no “right” beta. If we are lucky, the betas derived from dif- ferent sources will, for a given firm, be close together. If they are not, we will have less confidence in the CAPM cost-of-equity estimate.
Exhibit 9.1 contains the betas of some representative investor-owned healthcare businesses as provided by Reuters, an online information service. According to this limited selection, healthcare business lines, like all busi- nesses, appear to exhibit large differences in market risk for stockholders.
Company Symbol Primary Line of Business Beta
EXHIBIT 9.1 Beta
Aetna AET Managed care 0.87 Coefficients DaVita Inc. DVA Dialysis services 0.50 for Selected Fresenius Medical Care FMS.N Dialysis services 0.49 Healthcare HealthSouth Corp. HLS Outpatient/rehabilitation 1.66 Businesses Humana HUM Managed care 0.64 Laboratory Corp. LH Clinical laboratory services 0.58 Medtronic Inc. MDT Medical devices 0.98 Merck & Co. Inc. MRK Major pharmaceutical 0.38 Quest Diagnostics Inc. DGX Diagnostic testing 0.66 Universal Health Services Inc. UHS Acute care hospitals 1-54
Note: Historically, one had to obtain hard-copy reports from investment bankers or investment advisory firms to find the market betas of firms. Today, numerous websites supply this informa- tion in a matter of seconds.
Source: www.reuters.com/finance (February 2014).
382 Understanding Healthcare Finance Management
|i // Illustration of the CAPM Approach For an illustration of the CAPM approach, consider Ann Arbor Health C
On the web at: which has a beta coefficient, b, of 1.50. Furthermore, assume that the ’ ache.org/books/ rent on q^-bonds, RF, is 6.0 percent and that the best estimate for fo current market risk premium, RPM, is 5 percentage points. In other words the current required rate of return on the market, R(RM), is 11.0 percent' All required input parameters have been estimated. The SML equation can be completed as follows:
R(R) = RF + [R(RM) - RF] x b^
= 6.0% + (11.0% - 6.0%) x 1.50
= 6.0% + (5.0% x 1.50)
= 6.0% + 7.5%= 13.5%.
Thus, according to the CAPM, Ann Arbor’s required rate of ROE is 13.5 percent.
What does the 13.5 percent estimate for R(Re) imply? In essence, equity investors believe that Ann Arbor’s stock, with a beta of 1.50, is more risky than an average stock with a beta of 1.00. With a risk-free rate of 6.0 percent and a market risk premium of 5 percentage points, an average firm, with b = 1.0, has a required rate of ROE of 6.0% + (5.0% x 1.00) = 6.0% + 5.0% = 11.0%. Thus, according to the CAPM, equity investors require 250 basis points (2.50 percentage points) more return for investing in Ann Arbor, with b = 1.50, than in an average stock, with b = 1.00.
There is a great deal of uncertainty in the CAPM estimate of the cost of equity. Some of this uncertainty stems from the fact that there is no assur- ance that the CAPM is correct (i.e., the CAPM accurately describes the risk/ return preference of stock investors). Additionally, there is a great deal of uncertainty in the input parameter estimates, especially the beta coefficient. Because of these uncertainties, it is highly unlikely that Ann Arbor’s true, but unobservable, cost of equity is 13.5 percent. Thus, instead of picking single values for each parameter, it may be better to develop high and low estimates and then combine all of the high estimates and all of the low estimates to develop a range, rather than a point estimate, for the CAPM cost of equity.
Discounted Cash Flow Approach The second procedure for estimating the cost of equity is the DCF method. As we discuss in Chapter 7, the value of a stock with a predictable dividend stream can be found as the present value of that expected dividend stream. Furthermore, if the dividend is expected to grow each year at a constant rate, E(g), the constant growth model can be used to estimate the expected rate of ROE, E(Re):
Chapter 9: Cost of Capital 383
Because stock prices typically are in equilibrium, the expected rate of return, E(R), is also the required rate of return, R(R ).
Estimating the Current Stock Price As in the CAPM approach, there are three input parameters in the DCF model. Current stock price is readily available for actively traded firms from many financial websites. Currently, Ann Arbor’s stock price is $40, so Po = $40.
Estimating the Next Dividend Payment Next year’s dividend payment is also relatively easy to estimate. If you are one of Ann Arbor’s managers, you can look in the firm’s five-year financial plan for the dividend estimate. If you are an outsider, dividend data on larger pub- licly traded firms are available from many financial websites. Current dividend information can also be used as a basis for estimating next year’s dividend. Ann Arbor is followed by several analysts at major brokerage houses, and their consensus estimate for next year’s dividend payment is $2.50, so for purposes of this analysis, E(D1) = $2.50.
Estimating the Expected Growth Rate The expected growth rate, E(g), is the most difficult of the DCF model parameters to estimate. Here, we discuss several methods for estimating E(g).
Using Historical Growth Rates to Forecast Future Growth If growth rates in earnings and dividends have been relatively stable in the past and if investors expect these trends to continue, the past realized growth rate may be used as an estimate of the expected future growth rate. For an illustration of this concept, consider Exhibit 9.2, which lists earnings per share (EPS) and dividends per share (DPS) data from 2005 to 2014 for Ann Arbor. Ten years (nine growth periods) of data are shown in the exhibit, but we could have used 15 years, 5 years, or some other historical period. There is no rule about the appropriate number of years to analyze when calculating historical growth rates. However, the period chosen should reflect, to the extent possible, the longest period that replicates conditions expected in the future.
The easiest historical growth rate to calculate is the compound rate between two dates, called the point-to-point rate. For example, EPS grew at an annual rate of 6.8 percent from 2005 to 2014, and DPS grew at a 7.2 percent rate during this same period. Note that the point-to-point growth rate can change radically if we use two other points. For example, if we
384 Understanding Healthcare Finance Management
EXHIBIT 9.2 Ann Arbor Year EPS DPS
Health Care: 2005 $2.95 $1.24 Historical EPS 2006 3-07 !-32 and DPS Data 2007 3.22 1-32
2008 3-40 1-52 2009 4-65 1-72 2010 5-12 1.92
2011 5-25 2.00 2012 5.20 2.20 2013 5-12 2.20 2014 5-35 2-32
calculate the five-year EPS growth rate from 2009 to 2014, we would obtain only 2.8 percent. This radical change occurs because the point-to-point rate is extremely sensitive to the beginning and ending years chosen.
To alleviate the problem of beginning and ending year sensitivity, some analysts use the aveYage-to-avevqge method, which reduces the sensitivity of the growth rate to beginning and ending year values. The 2005-2007 aver- age EPS is ($2.95 + $3.07 + $3.22)/3 = $3.08, the average 2012-2014 EPS is ($5.20 + $5.12 + $5.35)/3 = $5.22, and the number of years of growth between the two averages is 2006 to 2013 = 7. The average-to-average DPS growth rate is 8.2 percent, and the average-to-average EPS growth rate is 7.8 percent. Note that we are calculating compound annual growth rates, which are much easier to interpret than a single growth rate over the entire period.
A third way, and in our view the best, to estimate historical growth rates is by lo^-lineaY least squares vegvession.6 The regression method considers all data points in the series; thus, this method is the least likely to be biased by a randomly high or low beginning or ending year. The only practical way to estimate a least squares growth rate is to use a computer or a financial cal- culator. Using a spreadsheet’s data regression capability, we find the growth rate in earnings to be 7.9 percent, while the growth rate in dividends is 7.7 percent.
When earnings and dividends are growing at approximately the same rate, we can have more confidence in the resultant growth rate forecast. However, if EPS and DPS historically have grown at different rates, some- thing will have to change in the future because these two series cannot grow at different rates indefinitely. There is no rule for handling differences in historical earnings and dividend growth rates; differences simply demonstrate in yet another way the problems with using historical growth as a proxy for expected future growth. Like many aspects of healthcare finance, judgment is required when estimating growth rates.
Chapter 9: Cost of Capital 385
Exhibit 9.3 summarizes the historical growth rates just discussed. It is obvious that one can take a given set of historical data and, depending on years and the calculation method used, obtain a large number of differ- ent growth rates. If past growth rates have been stable, investors might base future expectations on past trends. While this approach is reasonable, it is sel- dom feasible; one rarely finds much historical stability. Therefore, the use of historical growth rates in a DCF analysis must be applied with judgment and also used, if at all, in conjunction with the estimation methods discussed next.
Retention Growth Model The retention growth method is another method for estimating the expected growth rate in dividends:
E(g) = Retention ratio x Expected ROE.
This model produces a constant growth rate, and when we use it, we are, by implication, making four important assumptions: (1) We expect the payout ratio, and thus the retention ratio, to remain constant; (2) we expect the return on equity (ROE) on new investments to equal the firm’s current ROE, which implies that we expect the ROE to remain constant; (3) the firm is not expected to issue new common stock, or if it does we expect this new stock to be sold at a price equal to its book value; and (4) future projects are expected to have the same degree of risk as the firm’s existing assets. Ann Arbor has had an average ROE of about 14 percent over the past ten years. The ROE has been relatively steady, but even so, it has ranged from a low of 8.9 percent to a high of 17.6 percent during this period. In addition, the firm’s dividend payout ratio has averaged 0.45 over the past ten years, so its retention ratio has averaged 1.0 - 0.45 = 0.55. Using these data, the retention growth method gives a divided growth estimate of 7.7 percent:
E(gAAHS) = 0’55 X 14% = 7-7%-
This figure, together with the historical EPS and DPS growth rates summarized in Exhibit 9.3, might lead us to conclude that Ann Arbor’s expected dividend growth rate is in the range of 7.0 percent to 8.0 percent.
EXHIBIT 9.3 Method EPS DPS Average Ann Arbor
Point-to-point 6.8% 7.2% 7.0% Health Care: Average-to-average 7-8 8.2 8.0 Historical Log-iinear regression 7-9 7-7 7-8 Growth Rates,
2005-2014
386 Understanding Healthcare Finance Management
On the web at: ache.org/books/
UHFM7
Analysts’ Forecasts A third growth-rate estimation technique uses security analysts’ forecasts Analysts forecast and then publish growth rate estimates for most of the larger publicly owned businesses. For example, Value Line provides such forecasts on about 1,700 stocks, and all of the larger brokerage houses pro vide similar forecasts. Also, many online sites provide dividend forecast data Finally, several data collection firms compile analysts’ forecasts on a regular basis and provide summary information—such as the median and range of forecasts—on widely followed businesses. These growth-rate summaries— such as the ones compiled by Lynch, Jones & Ryan in its Institutional Brokers Estimate System (I/B/E/S, and currently owned by Thomson Reuters) and by Zacks Investment Research—can be ordered for a fee and obtained either in hard-copy format or through download. In addition, some data are available for free on the web.
The problem for our purposes is that most analysts’ forecasts correctly assume nonconstant growth. For example, some analysts that follow Ann Arbor are forecasting a 12.0 percent annual growth rate in earnings and divi- dends over the next five years, followed by a steady-state (constant) growth rate of 6.5 percent. A simple way to handle this situation is to use the non- constant growth forecast to develop a proxy constant growth rate. Computer simulations indicate that dividends beyond year 50 contribute little to the value of any stock—the present value of dividends beyond year 50 is virtually zero, so for practical purposes, anything beyond that point can be ignored. If we consider only a 50-year horizon, we can develop a weighted-average growth rate and use it as a constant growth rate for cost-of-capital purposes. For Ann Arbor, we assumed a growth rate of 12.0 percent for five years fol- lowed by a growth rate of 6.5 percent for 45 years, which produced an arith- metic average annual growth rate of (0.10 x 12.0%) + (0.90 x 6.5%) = 7.0%;
Illustration of the DCF Approach For an illustration of the DCF approach, consider the data developed thus far for Ann Arbor. The firm’s current stock price, PQ, is $40, and its next expected annual dividend, E(Dt), is $2.50. Thus, the firm’s DCF estimate of E(Rc) = R(Rc), according to the DCF model, is:
E(Re)-^^+E(g) 1 0
= ^+E(g) = 6.25% + E(g).
With an E(g) estimate range of 7 percent to 8 percent, the mid- point—7.5 percent—will be used as the final estimate. Thus, the DCF point estimate for Ann Arbor’s cost of equity is 6.25% + 7.5% = 13.75% ~ 13.8%.
Chapter 9: Cost of Capital 387
fjote, however, that it might be best to think of this estimate as a range of va|ues. say, from 13.3 percent to 14.3 percent—because of the uncertainty in the growth rate estimate.
If a company’s dividends are expected to grow at a constant rate for- ever, a simple model can be used to value its stock:
Key Equation 9.3: Constant Growth Dividend Valuation Model
E(Re) = D„x[l + E(g)] + Efe) = EfDj + E(g) •*■0 10
Here, E(R) is the expected rate of return on equity, which in equi- librium equals R(R), the required rate of return on equity; Do is the last dividend paid; E(g) is the expected constant dividend growth rate; Po is the current stock price; and E(DJ is the next expected dividend.
Debt-Cost-Plus-Risk-Premium Approach The debt-cost-plus-risk-premium approach relies on the assumption that stock investments are riskier than debt investments; hence, the cost of equity for any business can be thought of as the before-tax cost of debt to that business plus a risk premium:
R(Rc) = R(Rd) + Risk premium.
On the web at: ache.org/books/ UHFM/
The cost of debt is relatively easy to estimate, so the key input to this model is the risk premium.
Note that the risk premium used here is not the same as the market risk premium used in the CAPM. The market risk premium is the amount that investors require above the risk-free rate to invest in average-risk com- mon stocks. Here, we need the risk premium above the before-tax cost of debt. How might this new risk premium be estimated? Using previous data, we know that the cost of equity for an average risk (b = 1.0) stock is 11.0 percent. Furthermore, the cost of debt for an average firm, which has roughly an A rating, is 7.0 percent. Thus, for an average firm, the risk premium of the cost of equity over the cost of debt is 11.0% - 7.0% = 4.0 percentage points.
Empirical work suggests that, in recent years, the risk premium used in the debt-cost-plus-risk-premium model has ranged from 3 to 5 percentage points. When interest rates are high in the economy, this risk premium tends to be at the lower end of the range, while lower interest rates often lead to higher-risk premiums. Perhaps the biggest weakness of this approach is that there is no assurance that the risk premium for the average firm is the same
as the risk premium for the firm in question, which in this case is Aim A Thus, the risk premium method does not have the theoretical precision the other models do. On the other hand, the input values required b H debt-cost-plus-risk-premium model are fewer and easier to estimate than ■ the other models.
A business’s cost of equity can be estimated by adding a risk prcmiu to the business’s before-tax cost of debt:
Key Equation 9.4: Debt Cost Plus Risk Premium Model
R(Re) = R(Rd) + Risk premium.
Here, R(Re) is the cost of equity, R(Rd) is the before-tax cost of debt and the risk premium is the amount of return required above the cost of debt to induce investors to buy the business’s stock.
With a cost of debt estimate of 10.0 percent and a current risk pre mium estimate of 4.0 percentage points, the debt-cost-plus-risk-premiuni estimate for Ann Arbor’s cost of equity is 14.0 percent:
R(RC) = R(Rd) + Risk premium
= 10.0% + 4.0% = 14.0%.
Comparison of the CAPM, DCF, and Debt-Cost-Plus-Risk-Premium Methods We have discussed three methods for estimating the cost of equity. The CAPM estimate for Ann Arbor is 13.5 percent, the DCF estimate is 13.8 percent, and the debt-cost-plus-risk-premium estimate is 14.0 percent. At this point, most analysts would conclude that there is sufficient consistency in the results to warrant the use of 13.8 percent, or thereabout, as the final estimate of the cost of equity for Ann Arbor. If the three methods had pro- duced widely different estimates, Ann Arbor’s managers would have had to use their judgment regarding the relative merits of each estimate and then chosen the estimate, or some average of the estimates, that seemed most rea- sonable under the circumstances. If one of the estimates is clearly out of the ballpark, it would be best to discard that estimate rather than average it in with the others. In general, the choice of which methods and weights to use in making the final estimate would be based on the managers’ confidence in the input parameters and the relative values of each approach.
SELF-TEST QUESTIONS 1. Describe the CAPM approach to estimating a business’s cost of
equity.
Chapter 9: Cost of Capital 389
2. What is the best proxy for the risk-free rate in the CAPM? Why? 3. What are the three types of beta that can be used in the CAPM? 4. Describe the DCF approach to estimating a business’s cost of
equity. 5. What are three common methods for estimating the future
dividend growth rate for use in the DCF model? 6. Describe the debt-cost-plus-risk-premium approach to estimating a
business’s cost of equity. 7. Is there a difference between the risk premium used in the CAPM
and the one used in the debt-cost-plus-risk-premium model? 8. How would you choose among widely different estimates of R(R)?
SELF-TEST QUESTIONS
Estimating the Cost of Equity to Not-for-Profit Businesses
Not-for-profit businesses raise equity (i.e., fund) capital in two basic ways: (1) by receiving contributions and grants and (2) by earning an excess of revenues over expenses (retained earnings). In this section, we discuss some views regarding the cost of fund capital and then illustrate how this cost might be estimated.
Is There a Cost to Fund Capital? Our primary purpose in this chapter is to develop a corporate cost-of-capital estimate that can be used in capital budgeting decisions. Thus, the estimated “costs” represent the cost of using capital to purchase fixed assets, rather than for alternative uses. What is the cost of using equity capital for real-asset investments in not-for-profit businesses? At least five positions can be taken on this question:8
Fund capital has a zero cost. The rationale here is that (1) contributors do not expect a monetary return on their contributions and that (2) the firm’s stakeholders, especially the patients who pay more for services than warranted by the firm’s tangible costs, do not require an explicit return on the capital retained by the firm. Because no explicit monetary return is required by the suppliers of fund capital, its cost is zero. Fund capital has a cost equal to the return forgone on marketable securities investments. When a not-for-profit firm receives contributions or retains earnings, it can always invest these funds in marketable securities (highly liquid, safe securities) rather than
390 Understanding Healthcare Finance Management
immediately use these funds to purchase real assets (property and equipment). Thus, fund capital has an opportunity cost that should be acknowledged; this cost is roughly equal to the return available on a portfolio of short-term, low-risk securities such as T-bills. Because such securities provide relatively low returns, the cost of fund capital is relatively small.
3. Fund capital has a cost equal to the expected growth rate of the busmess’s assets.9 To better understand the logic here, assume that a hospital in a growing city must increase its services to meet growing demand and, because it does not have excess capacity, its total assets must increase by 8 percent per year to keep pace with the increasing patient load. Because the left side of the balance sheet (total assets) must increase by 8 percent, the right side (total capital) also must increase by the same amount to keep the balance sheet balanced. To increase its capital without increasing the proportion of debt used to finance its assets, the hospital must grow its fund capital at an 8 percent rate. In this way, it can finance asset growth by growing both debt and equity at the same 8 percent rate as assets and hence hold the relative amount of debt constant. If the hospital earned zero return on its fund capital, its equity base would remain constant over time, and the only way it could add new assets would be to take on additional debt without matching equity (and hence drive up its debt ratio) or rely solely on contributions to provide the needed equity. In general, reliance on contribution capital is highly risky, and, at some point, lenders will be unwilling to provide additional debt financing, so it would be difficult to support the desired growth without a return on the equity invested.
Even if no volume growth is expected, a not-for-profit business must earn a return on its fund capital just to replace its existing asset base as assets wear out or become obsolete. This ROE is required because new assets will cost more than the old ones being replaced due to tech- nological advances and inflation, so depreciation cash flow in itself will not be sufficient to replace worn-out and obsolete assets as needed. The bottom line here is that not-for-profit firms must earn an ROE merely to support dollar growth in assets, and the greater the growth rate—includ- ing that caused by inflation—the greater the cost of fund capital.
4. Fund capital has a cost equal to that required to maintain the business’s creditworthiness. One of the factors that rating agencies consider when assigning credit ratings is the profitability of the business; all else the same, the higher the profitability, the higher the credit rating. In general, managers of not-for-profit healthcare businesses have some target credit rating that they desire to maintain. Failure to maintain a
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sound credit rating increases both the cost of debt (interest rate) and the difficulties involved in obtaining future debt financing. Rating agencies periodically publish financial measures that they believe to be appropriate for each credit rating. In addition, numerous providers of hospital financial data publish financial measure averages by bond rating. For example, if the average A-rated hospital has an ROE of 7 percent, and a not-for-profit hospital wants to maintain an A rating, its target ROE (and hence cost of fund capital) should be about 7 percent.
5. Fund capital has a cost equal to the cost of equity to similar for- profit businesses. The rationale here rests on the opportunity cost concept as discussed in the second argument, but the opportunity cost is now defined as the return available from investing fund capital in alternative investments of similar risk rather than from investing in low-risk marketable securities.
For an illustration of this position, suppose Bayside, a not-for-profit corporation, receives $500,000 in contributions in 2014 and also retains $4.5 million in earnings, so it has $5 million of new fund capital available for investment. The $5 million can be (1) used to purchase assets related to its core business, such as an outpatient clinic or diagnostic equipment; (2) tem- porarily invested in securities, with the intent of purchasing healthcare assets sometime in the future; (3) used to retire debt; (4) used to pay management bonuses; (5) placed in a non-interest-bearing account at a bank; and so on. By using this capital to invest in real assets (property and equipment), Bayside is deprived of the opportunity to use this capital for other purposes, so an opportunity cost must be assigned that reflects the riskiness associated with an equity investment in hospital assets. What return is available on securities with similar risk to an equity investment in hospital assets? The answer is the return expected from investing in the stock of an investor-owned hospital business, such as Ann Arbor Health Care. Instead of using fund capital to purchase real healthcare assets, Bayside can always use the funds to buy the stock of a hospital business, such as Ann Arbor, and delay the real-asset pur- chase until sometime in the future.
Of these five positions, which should prevail in practice? Unfortunately, the answer is not clear-cut. However, at a minimum, a not-for-profit business should require a return on its equity investment in real assets that is at least as large as its projected asset growth rate. In that way, the business is setting the minimum rate of return that will, if it is actually achieved, ensure that the forecasted growth rate can be achieved. Thus, the expected growth rate sets the minimum required rate of return, and hence the minimum cost of equity, for not-for-profit businesses. On the other hand, if the rating agency’s target ROE is greater than the growth rate, it would be prudent to use this value
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Choosing a Cost of Equity When Estimates Vary Widely
Suppose you are estimating the cost of capital for a large, publicly traded for-profit hospital chain. First, you estimated the cost of debt to be 7.2 percent. Then, you applied all three methods for estimating the hospital’s cost of equity, with the following results:
CAPM: 13.6% DCF: 6.8% Debt cost plus risk premium: 11.2%
Your next task is to choose a single value for the cost of equity.
How do you estimate a single value from these widely different estimates? Should you merely average the three estimates or should other factors be considered. Does the fact that the DCF estimate is less than the cost of debt influence your decision? What is your best single (point) estimate for the hospital’s cost of equity?
as the cost of equity to ensure the busin maintains its creditworthiness.
However, to fully recover all opportunity costs, including the OppOr tunity cost of employing equity capita] in real assets, the real-asset investments must offer an expected return equal to the return expected on similar-risk securities investments. Thus, the “true” economic cost of equity to a not-for-profit health- care provider is the rate that can be earned on stock investments in similar investor- owned firms. By using this cost of equity, a not-for-profit business is requiring that all costs, including full opportunity costs, be considered in the cost-of-capital estimate. Although we believe the full oppor- tunity cost approach to be most correct theoretically, many would argue that the unique mission of not-for-profit businesses precludes securities investments as realistic alternatives to healthcare property-and-
equipment investments because securities investments do not contribute directly to the mission of providing healthcare services. If that is the case, the cost of fund capital should be the greater of the expected growth rate or the rate required to maintain creditworthiness. On the other hand, full opportu- nity costs do not have to be recovered on every new capital investment. Not- for-profit firms do invest in negative profit projects that benefit their stakeholders, but we believe that managers should be aware of the financial opportunity costs inherent in such investments. We have more to say about this issue in Chapter 11.
SELF-TEST QUESTIONS 1. Is there a cost of equity for not-for-profit businesses?
2. How can this cost be estimated?
EgEstimating the Corporate Cost of Capital On the web at:
ache.org/books/ UHFM7
The final step in the cost-of-capital estimation process is to combine the debt and equity cost estimates to form the corporate cost of capital (CCC). As we discuss in Chapter 10, each business has a target capital structure in mind, which is defined as the particular mix of debt and equity that causes its overall cost of capital to be minimized. Furthermore, when a business raises new
Chapter 9: Cost of Capital 393
tai it generally tries to finance in a way that will keep the actual capital Cffucture reasonably cl°se to *ts tarSet over bme- The CCC for any business, S. ardless of ownership, is calculated using the following equation: reg
Key Ration 9.5: Corporate Cost of Capital CCC = [wd x R(Rd) x (1 - T)] + [we x R(R)].
Here, CCC is the corporate cost of capital, wd is the weight of debt financing in the optimal (target) capital structure, R(Rd) is the cost of debt, T is the tax rate, wc is the weight of equity, and R(Re) is the cost of equity.
Here, wd and we are the target weights for debt and equity, respec- tively. The cost of the debt component, R(Rd), will be an average if the firm uses several types of debt for its permanent financing. Alternatively, the above equation can be expanded to include multiple debt terms. Investor-owned businesses would use their marginal tax rate for T, while T would be zero for not-for-profit firms.
The CCC represents the cost of each new dollar of capital raised at the margin. It is not the average cost of all the dollars that the firm has raised in the past. Our primary interest is in obtaining a cost of capital for use in capital investment analysis; for such purposes, a marginal cost is required. The CCC formula implies that each new dollar of capital will consist of both debt and equity that is raised, at least conceptually, in proportion to the firm’s target capital structure.
Investor-Owned Businesses For an illustration of the CCC calculation for investor-owned businesses, consider Ann Arbor, which has a target capital structure of 60 percent debt and 40 percent equity. As previously estimated, the firm’s before-tax cost of debt, R(Rd), is 10.0 percent; its tax rate, T, is 40 percent; and its cost of equity, R(Re), is 13.8 percent. Using these data, we estimate Ann Arbor’s CCC to be 9.1 percent:
CCCAAHS = K X R(Rd) X (! - T)J + K X R(Re)l
= [0.60 X 10.0% X (1 - 0.40)] + [0.40 x 13.8%]
= 9.1%.
Conceptually, every dollar of new capital that Ann Arbor obtains consists of 60 cents of debt (with an after-tax cost of 6.0 percent) and 40 cents of equity (with a cost of 13.8 percent). The average cost of each new dollar is 9.1 percent. In any one year, Ann Arbor may raise all of its required new capital by issuing debt, by retaining earnings, or by selling new common stock. Over the long
run, Ann Arbor plans to use 60 percent debt financing and 40 percent ea • financing, so these weights are appropriate for the cost-of-capital calculation
Not-for-Profit Businesses The CCC for not-for-profit businesses is developed in the same way as fOr investor-owned businesses. For an illustration, consider the following exam pie. If we assume a target capital structure of 50 percent debt and 50 percent equity and use the estimates of the component costs developed earlier the CCC for Bayside is 10.2 percent:
CCCBMH = K X R(Rd) X (* - T)] + K X R(Re)l
= [0.50 X 6.1% X (1 - 0)] + [0.50 X 14.2%]
= 10.2%.
The primary reason that Bayside’s corporate-cost-of-capital estimate is greater than Ann Arbor’s is that Ann Arbor uses more debt financing in its target mix and hence uses more of the lower-cost financing component. Perhaps Ann Arbor, as a hospital system, has lower business risk and hence can carry more debt in its optimal financing structure. (This issue is pursued in Chapter 10.)
Businesses, regardless of ownership, cannot raise unlimited amounts of new capital in any given year at a constant cost. Eventually, as more new capi- tal is raised, investors will require higher returns on debt and equity capital, even though the capital is raised in accordance with the firm’s target struc- ture. Thus, the CCCs estimated here for Ann Arbor and Bayside are valid only when the amount required for capital investment falls within each busi- ness’s normal range. If capital is required in amounts that far exceed those normally raised, the CCC must be subjectively adjusted upward to reflect the higher costs involved.
SELF-TEST QUESTIONS 1. What is the general formula for finding the CCC?
2. What weights should be used in the formula? Why? 3. What is the primary difference between the CCCs for investor-
owned and not-for-profit firms? 4. Is the CCC constant regardless of the amount of new capital
required? Explain your answer.
An Economic Interpretation of the Corporate Cost of Capital
Thus far, the focus of the cost of capital discussion has been on the mechan- ics of the estimation process. Now, it is worthwhile to step back from the
mathematics of the process and examine the economic interpretation of the
ccc. The component cost estimates (the costs of debt and equity) that
make up a business’s CCC are based on the returns that investors require to supply capital to the firm. In turn, investors’ required rates of return are based on the opportunity costs borne by investing in the debt and equity of the business in question, rather than in alternative investments of similar risk. These opportunity costs to investors, when combined to estimate the CCC, establish the opportunity cost to the business—that is, the CCC is the return that the business can earn by investing in alternative security invest- ments that have the same risk its own real assets have. From a pure financial perspective, if a business cannot earn its CCC on new capital investments, no new investments should be made and no new capital should be raised. If existing investments are not earning the CCC, they should be terminated, the assets liquidated, and the proceeds returned to investors for reinvestment elsewhere.
Note that the CCC sets the minimum return required on real-asset investments regardless of the actual financing anticipated during the planning period—that is, even if Ann Arbor planned to finance all new capital investments with debt financing, which has an estimated after-tax cost of 6.0 percent, the appropriate cost of capital to the firm is 9.1 percent. The rationale is that the debt financing cannot be obtained at the current cost rate without Ann Arbor’s equity base, so from an economic perspective, the new capital investments are actually being financed using both equity and debt— that is, being financed at the firm’s target capital structure.
However, the CCC is not the appropriate minimum rate of return for all new real-asset investments. The required rates of return set by investors on the business’s debt and equity arc based on perceptions regarding the riski- ness of their investments, which, in turn, are based on two factors: (1) the inherent riskiness of the business and (2) the amount of debt financing used. Thus, the firm’s inherent business risk and capital structure are embedded in its CCC estimate.
Because different firms have different business risk and use different proportions of debt financing, different firms have different CCCs. Different capital costs are most pronounced for firms in different industries; stocks of high-tech businesses, for example, often have higher beta values than health- care stocks do. Still, even firms in the same industry can have different busi- ness risk, and capital structure differences among such firms can compound CCC differences.
The primary purpose of estimating a business’s CCC is to help make capital budgeting decisions—that is, the cost of capital will be used as the benchmark capital budgeting hurdle rate, which is the minimum return nec- essary for a project to be attractive financially. The firm can always earn its
396 Understanding Healthcare Finance Management
cost of capital by investing in securities that in the aggregate have the same risk as the firm’s assets, so it should not invest in real assets unless it can earn at least as much. However, remember that the CCC reflects opportunity- costs based on the aggregate risk of the firm (i.e., the riskiness of the firm’s average project). Thus, the CCC can be applied without modification only to projects under consideration that have average risk, where average is defined as that applicable to the firm’s currently held assets in the aggregate. If a project under consideration has risk that differs significantly from that of the firm’s average asset, the corporate cost of capital must be adjusted to account for the differential risk when the project is being evaluated.10
For example, Ann Arbor’s CCC—9.1 percent—is probably appropri- ate for use in evaluating a new outpatient clinic that has risk similar to the hospital’s average project, which involves the provision of both inpatient and outpatient services. Clearly, it would not be appropriate to apply Ann Arbor’s 9.1 percent CCC without adjustment to a new project that involves establish- ing a managed care subsidiary; this project does not have the same risk as the hospital’s average asset.
As discussed in Chapter 5, investors require higher returns for riskier investments. Thus, a high-risk project must have a higher project cost of capi- tal than a low-risk project must have. Exhibit 9.4 illustrates the relationships among project risk, the CCC, and project cost of capital. The exhibit illus- trates that Ann Arbor’s 9.1 percent CCC is the appropriate hurdle rate only for an average risk project such as Project A, which has the same risk as the aggregate business. Project L, which has less risk than Ann Arbor’s average project, has a project cost of capital of 7.1 percent, which is less than the CCC. Conversely, Project H, which has more risk than the average project, has a higher project cost of capital of 11.1 percent.
The key point here is that the CCC is merely a benchmark that will be used as the basis for estimating project costs of capital. It is not a one-size- fits-all rate that can be used with abandon whenever an opportunity cost is needed in a financial analysis. This point is revisited in Chapter 12 when capi- tal investment risk considerations are addressed.
SELF-TEST QUESTIONS 1. Explain the economic interpretation of the CCC.
2. Is the CCC affected by short-term financing plans? Explain your answer.
3. Is the CCC the appropriate opportunity cost for all projects that a business evaluates?
4. Draw a graph similar to the one shown in Exhibit 9.4 and explain its implications.
Project Cost of Capital
(Project A)
EXHIBIT 9.4 Ann Arbor Health Care: Corporate and Project Costs of Capital
Flotation Costs
In our discussion of the CCC, we have ignored flotation (issuance) costs, which are the administrative costs and fees required to bring new securities to market. Under some circumstances, such costs can be large, especially for equity issues. One way of handling flotation costs is to incorporate them into the CCC estimate, which has the effect of increasing the CCC. Here are some points to consider regarding flotation costs:
• Mature for-profit businesses rarely issue new common stock. Rather, it is cheaper to obtain equity capital by earnings retention, which eliminates flotation costs. Furthermore, flotation costs on public debt issues are relatively small, while such costs on private placements are near zero. Thus, only businesses that must go to the equity markets frequently bear substantial flotation costs.
• There is considerable uncertainty inherent in the cost-of-capital estimation process. Thus, attempting to fine-tune the resulting estimate by incorporating flotation costs may be an exercise in futility.
• When flotation costs are significant, they can be incorporated into the decision process by adding them to the cost of the capital investments
39« Understanding Healthcare Finance Management
under consideration. Thus, if new capital to fund a business’s new investments requires $2 million in flotation costs, this dollar cost can be assigned directly to the projects under consideration.
For these reasons, we have chosen not to incorporate flotation costs into the estimation process.11
SELF-TEST QUESTION 1. Are flotation costs relevant to the CCC estimate? Explain your
answer.
Divisional Costs of Capital
The CCC reflects the riskiness of the overall business in the aggregate. If a firm has only one line of business, the CCC can be used—with appropriate risk adjustments—on most projects under consideration. However, the CCC may not be the appropriate benchmark (starting point) for projects that are in a line of business that differs from the overall firm.
When a firm has multiple divisions that operate in different business lines, it may be best to estimate a divisional cost of capital for each division and use these estimates as the benchmarks for all capital project evaluations. The assumption here is that capital budgeting analyses will be conducted at the divisional level, so the best benchmark for such analyses is the one that reflects the riskiness of each division’s business line.
For an illustration of this concept, consider the following example. A for-profit healthcare system might, along with its provider network, have one subsidiary that invests primarily in real estate for medical uses and another subsidiary that runs an HMO. Clearly, each of these subsidiaries has its own unique business risk and optimal capital structure. The low-risk, high-debt- capacity real estate subsidiary might have a divisional cost of capital of 8 percent, while the high-risk, low-debt-capacity HMO subsidiary might have a cost of capital of 12 percent. The health system, which consists of these two divisions plus provider assets, would likely have a cost of capital that falls between 8 and 12 percent—say, 10 percent.
If all capital budgeting decisions within the system were made on the basis of the system’s 10 percent CCC, the process would be biased in favor of the higher-risk HMO subsidiary. The cost of capital would be too low for the HMO subsidiary and too high for the real-estate subsidiary. Over time, this cost-of-capital bias would result in acceptance of too many HMO proj- ects and too few real-estate projects, which would skew the business-line mix toward HMO assets and hence increase the overall riskiness of the system. Of
r Chapter 9: Cost of Capital 399 course, the answer to this problem is to use subsidiary costs of capital rather than the CCC in the capital budgeting decision process.
Unlike individual project costs of capital, subsidiary costs of capital often can be estimated with some confidence because it is usually possible to identify publicly traded firms that are predominantly in the same line of business as the subsidiary. For example, the cost of capital for the HMO sub- sidiary can be estimated by looking at the debt and equity costs of the major for-profit managed care companies, such as Humana and UnitedHealth Group. This approach, in which a publicly traded firm in the same line of business is used as a proxy for a nonpublicly traded business, is called the pure play approach. If market data are at hand for pure play firms, it is relatively easy to develop subsidiary costs of capital.
As a final check in the process of estimating divisional costs of capital, note that the CCC must equal the weighted average—say, by proportion of assets—of all of the subsidiary costs of capital. If it does not, there are prob- lems in the estimation process that must be resolved.
1. Explain the concept of divisional costs of capital. SELF-TEST QUESTION
Warning! Warning! Warning!
We have spent a great deal of time describing how the corporate (or divi- sional) cost of capital is estimated for any business. In addition, we have discussed the interpretation and use of the corporate (or divisional) cost of capital as a hurdle rate in evaluating new capital investment proposals. Once the effort has been expended to estimate the cost of capital, there is a strong tendency (especially among students) to treat the estimate as a one-size - fits-all number—that is, “we have a project to consider—no sweat, use the cost-of-capital estimate as the hurdle rate.” Unfortunately, the corporate (or divisional) cost of capital cannot be applied willy-nilly. As we discussed earlier, if the project being evaluated does not have average risk, a risk adjustment— as illustrated in Exhibit 9.4—must be applied.
Equally important, if the project under consideration is in a line of business that is unrelated to the core business, the corporate (or divi- sional) cost of capital cannot be used. For example, assume that a hospital is considering acquiring a medical group practice. Is it appropriate to use the hospital’s CCC as the base hurdle rate in the analysis? The answer is no! Because the project being evaluated (a medical practice) is in a different line of business than the hospital, the CCC is not relevant to the analysis. The appropriate cost of capital is one developed using the pure play method
L. _______
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as the (discussed in the next section) with practice management businesses proxy.
SELF-TEST QUESTION 1. When is it appropriate to apply the CCC when evaluating a new
project proposal? When is it inappropriate?
Cost-of-Capital Estimation for Small Businesses
The guidance given thus far in the chapter focuses on the cost-of-capital estimation process for large healthcare businesses. What if the business is small, such as a solo practice; a small group practice; or a small, freestanding hospital? The estimation process is the same as described, but the manner in which the component costs are estimated must be handled differently.
Estimating the Cost of Debt Small businesses typically obtain the bulk of their debt financing from com- mercial banks, so a business’s commercial loan officer will be able to provide some insights on the cost of future debt financing. Alternatively, managers of small businesses can look to marketplace activity for guidance—that is, the interest rate currently being set on the debt issues of similar-risk firms can be used as an estimate of the cost of debt? Here, similar risk can be judged by subjective analysis (same industry, similar size, similar use of debt, and so on). In many cases, the prime rate gives small businesses a benchmark for bank loan rates. If the business has borrowed from commercial banks in the past, its managers will know the historical premium charged above the prime rate for the business’s bank debt. An awareness of the current interest rate environment generally permits managers to make a reasonable estimate for their own business’s cost of debt, even when the business is small.
Estimating the Cost of Equity Although estimating the cost of debt for a small business is relatively easy, the cost-of-equity estimate is more problematic because such businesses do not have publicly traded stock.
Debt-Cost-Plus-Risk-Premium Approach Perhaps the easiest way to estimate the cost of equity of a small business is to use the debt-cost-plus-risk-premium method. Because the cost of debt is relatively easy to estimate, it is equally easy to add some risk premium—say, 4 percentage points—to the business’s before-tax cost of debt to obtain its cost-of-equity estimate. However, this estimate can be considered only a
ballpark estimate because the risk premiums applicable to small businesses , not be the same as those estimated for large firms.
pure Play Approach \s an alternative, a proxy publicly traded firm in the same line of business can be identified and its beta used to estimate the equity risk of the small business. This approach is the pure play method first mentioned in the last major section. For example, suppose the beta for a publicly traded practice management firm is 0.88. If the riskiness inherent in practice manage- ment is the same as the risk involved in the ownership of a small group practice, a beta of 0.88 can be used to proxy such ownership risk. Then, the CAPM approach can be used to estimate the small business’s cost of equity. As in our discussion in the chapter supplement, Hamada’s equation could be applied to refine the beta estimate, but the uncertainties involved make such refinements of dubious value.
To use the pure play approach for a small business, we must assume that the risk to the owners of the publicly traded proxy firm is the same as the risk to the owners of the small business. However, there are several important differences between the ownership of stock in a large corporation and the ownership of, say, a small group practice. First, the geographic and business- line diversification of a large business typically makes ownership less risky than a similar position in a small, localized single-line business. In effect, the port- folios of business projects of large firms are better diversified than the port- folios of small firms. Second, most stockholders of large businesses hold that stock as part of a well-diversified investment portfolio that has returns that are not highly correlated with the stockholders’ employment earnings. With a small group practice, employment returns to physicians often are more substantial than those associated with ownership and are highly correlated with one another. Third, stock owned in an investment portfolio is highly liquid—the owner can sell it quickly at a fair market price with a single phone call. Conversely, an ownership position in a group practice is difficult to sell. All of these factors suggest that the cost of equity to a small-owner- managed business is higher, perhaps much higher, than that calculated using the CAPM and a proxy company. Unfortunately, finance theory cannot tell us how much higher.
Build-Up Method An approach called the build-up method is commonly used to estimate the cost of equity for small businesses. Here, the cost of equity of a similar large business is used as the base, or starting point. Then, various adjustments, or premiums, are added to account for the differences between large and small businesses.
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• Size premium. Although returns data on businesses as small as a group practice are not readily available, studies using historical returns data indicate that the cost of equity for the smallest stocks (those in the bottom decile of market value) listed on the NYSE is about 4 percentage points higher than the cost of equity for large businesses (those in the S&P 500). This premium—added to compensate for the additional risk inherent in the ownership of small, as opposed to large businesses—is called the size premium. It can be argued that the size premium is even larger than 4 percentage points for firms so small that their equity is not publicly traded. The bottom line here is when the cost of equity of a small business is estimated on the basis of equity costs to similar large businesses, an additional premium must be added to account for the size differential.
• Liquidity premium. Because an ownership position in a small business is less liquid than the stock of a large corporation, a liquidity premium is commonly added when estimating the cost of equity for a small business. This premium is generally thought to be about 2 percentage points. Note, however, that if an investor has a control position (more than 50 percent ownership), some of the risk associated with small business ownership is reduced.
• Unique risk premium. Some small businesses have unique risk. For example, the success of a start-up business might depend on new, unproven technology, or the success of a small business might depend on the intellectual capital or managerial prowess of one person. In such situations, an equity investment is very risky, and it is not uncommon to add a premium of 5 or more percentage points to account for such unique risk.
For an illustration of the use of the build-up method, consider a small medical practice. The cost of equity to a large practice management company is found as follows:
R(R) = RF + [R(RM) - RF] x b
= 6.0% + (11.0% - 6.0%) x 0.88
= 6.0% + (5.0% x 0.88) = 10.4%
Here, we used a pure play beta of 0.88 along with the market data used in previous examples to obtain a base cost of equity of 10.4 percent.
Now, using the build-up method, and assuming a size premium of 4 percentage points and a liquidity premium of 2 percentage points, we obtain a cost of equity estimate of
Chapter 9: Cost of Capital 403
Cost of equity = 10.4% + 4.0% + 2.0% = 16.4%.
If any unique risk is identified for this practice, the cost-of-equity esti- mate could be even higher.
Although the estimation process clearly is more difficult, it may be even more important for small businesses to recognize their CCCs than it is for large businesses. The reason is that in small businesses, owners often have their livelihoods, as well as their equity investment, tied to the business. Using the techniques described in this section, even a small business owner can attempt to estimate her business’s CCC.
1. What problems do small businesses face when estimating the CCC?
2. What is the size premium? Liquidity premium? Unique risk premium?
3. Describe the build-up method for estimating a small business’s cost of equity.
SELF-TEST QUESTIONS
Factors That Influence a Business’s Cost of Capital
The CCC estimate for any business is influenced by several factors. Some are external to the business, but some can be influenced by managerial actions.
Factors That Cannot Be Influenced • The level of interest rates. The factor that perhaps has the greatest
impact on a business’s cost of capital is the general level of interest rates, which typically is a function of inflation expectations. In the early 1980s, interest rates were very high; hence, CCCs were very high. In such circumstances, only projects that will yield a very high return are acceptable; as a result, capital investment is low. Conversely, in recent years, interest rates in the United States have been low, so the costs of capital have been relatively low.
• Tax rates. High corporate tax rates lead to a lower cost of capital because the cost of debt for investor-owned businesses is reduced by one minus the tax rate. At the same time, differential personal taxes encourage the use of one form of capital over another. For example, a capital gains tax rate that is lower than the ordinary tax rate lowers the cost of equity to taxable businesses relative to the cost of debt and hence encourages the use of equity financing. High personal tax rates
Understanding Healthcare Finance Management
also affect the cost of debt to not-for-profit businesses because high tax rates make tax-exempt debt more attractive to investors and hen lower the cost of tax-exempt (municipal) debt capital.
Factors That Can Be Influenced • Capital structure policy. As we discuss in the next chapter, the
optimal capital structure is the structure that produces the lowest cost of capital to the business. Thus, businesses that are not using the optimal proportion of debt financing have a CCC that is higher than necessary.
• Capital investment policy. A business’s capital investment policy defines its line of business, which establishes the basic risk of the business. If a business adds more and more risky assets to its fixed asset portfolio, its CCC will increase. Likewise, the addition of low-risk assets will lower the cost of capital. Don’t forget, however, that the CCC is merely a benchmark, and new projects that have differential risk as compared with the business as a whole must use a cost of capital that differs from the CCC.
SELF-TEST QUESTION 1. What are the factors that affect the CCC estimate?
Chapter Key Concepts This chapter discusses the CCC, which is important to the financial well- being of healthcare businesses. Here are its key concepts:
• The cost of capital to be used in capital budgeting decisions is the weighted aver tige of the various types of permanent capital the firm uses, typically debt and common equity.
• The component cost of debt is the after-tax cost of new debt. For taxable businesses, it is found by multiplying the before-tax cost of new debt by (1 - T), where T is the firm’s marginal tax rate, so the component cost of debt is R(Rd) x (1 - T). For not-for-profit businesses, the debt is often tax-exempt, but no other tax effects apply, so the component cost of debt is merely the tax-exempt R(Rd).
• The cost of equity for an investor-owned business is the rate of return investors require on the firm’s common stock. For large businesses, it is usually estimated by three methods: (1) the Capital
Chapter 9: Cost of Capital 405
Asset Pricing Model (CAPM) approach, (2 ) the discounted cash flow (DCF) approach, and (3) the debt-cost-plus-risk-premium approach. In the CAPM approach, the firm’s beta coefficient is multiplied by the market risk premium to determine the firm’s risk premium, and this risk premium is added to the risk-free rate to obtain the firm’s cost-of-equity estimate. The best proxy for the risk-free rate is the yield on long-term T-bonds. Three types of betas can be used in the CAPM: (1) historical, (2) adjusted, and (3) fundamental. The market risk premium can be estimated either historically or prospectively. The DCF approach uses the dividend valuation model, which requires the current stock price, last dividend paid, and dividend growth rate to estimate the cost of equity. The growth rate can be estimated from historical dividend data (by using the retention growth model) or from securities analysts’ forecasts. The debt-cost-plus-risk-premium approach adds a risk premium to the firm’s cost-of-debt estimate to obtain the cost-of-equity estimate. For not-for-profit businesses, the cost of equity (fund capital) can be approximated by the cost of equity of similar investor-owned firms. This approach considers the opportunity costs associated with the use of equity capital. Alternatively, the cost of equity to not-for-profit businesses can be set as the greater of the expected asset growth rate and the rate required to maintain creditworthiness. This approach does not consider opportunity costs, but it does recognize that a ROE is required if the business is to maintain a sound financial posture. Each firm has a target capital structure, and the target weights are used to estimate the firm’s corporate cost of capital (CCC):
CCC = [Wd X R(Rd) X (1 - T)] + [We X R(R )].
When making capital investment decisions, the firm will use the CCC as the hurdle rate for average-risk projects. Note, however,
(continued)
406 Understanding Healthcare Finance Management
(continued from previous page)
that the CCC is irrelevant if the project being analyzed is in a different line of business than the core business.
• If a business has multiple divisions that operate in different business lines, it is best to estimate a divisional cost of capital for each division.
• The CCC for small businesses is estimated by using the same techniques as applied for large businesses. However, the estimation of the component costs—particularly the cost of equity—is more difficult.
• The build-up method is used to estimate the cost of equity for a small business. This method uses the cost of equity of a similar large business as the starting point and then adds (1) a size premium, (2) a liquidity premium, and (3) a unique risk premium.
• Several factors influence the cost-of-capital estimate for any business, including (1) the current level of interest rates, (2) tax rates, (3) capital structure policy, and (4) capital investment policy.
The concepts developed in this chapter are used extensively throughout the text, especially in capital structure decisions (Chapter 10) and in capital budgeting decisions (chapters 11 and 12).
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
• A chapter model that shows how to perform many of the calculations described in the chapter
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and tests your
ability to perform the calculations in preparation for a case
These resources can be accessed on the book’s companion website at ache.org/books/UHFM7.
Selected Case
One case in Cases in Healthcare Finance, 5th edition, is applicable to this chapter:
Case 16: Southeastern Homecare, which focuses on the cost of capital estimation process for both investor-owned and not-for-profit businesses.
Selected Bibliography
Carpenter, C. E., and P. M. Bernet. 2013. “How the Choice of Issuing Authority Affects Hospital Debt Financing Costs.” Health care Financial Management & (5): 80-84.
Gordon, D. C. 2010. “Squeezing the Funding You Need from Today’s Capital Sources.” Healthcare Financial Management 64 (4): 47-55.
McCue, M. J., and T. H. Kim. 2007. “Evaluating the Underlying Factors Behind Variable Rate Debt.” Health Care Management Review 32 (4): 300-08.
McNulty, J. J., T. D. Yeh, W. S. Schulze, and M. H. Lubatkin. 2002. “What’s Your Real Cost of Capital?” Harvard Business Review 80 (10): 114-21, 130.
Ponton, K. T., and J. P. Darcy. 2006. “No Longer Your Mother’s Muni Market.” Healthcare Financial Management 60 (7): 102, 104.
Sussman, J. H., M. W. Louge, and R. J. McKeown. 2006. “Developing and Imple- menting a Comprehensive Debt Management Policy.” Healthcare Financial Management 60 (8): 80-86.
Sussman, J. H., M. E. Grube, and D. Samaris. 2009. “Ensuring Affordability of Your Hospital’s Strategies.” Healthcare Financial Management 63 (5): 42^18, 50.
Selected Websites
The selected websites listed at the end of chapters 6 and 7 are applicable to cost-of-capital estimation.
• For some interesting information related to cost-of-capital estimation, see the Duff & Phelps website at http://duffandphelps.com/. Click on Expertise, and then Cost of Capital. You will see a list of available products.
• For an illustration of a real-world cost-of-capital calculation, see the Expectations Investing website at http://expectationsinvesting.com. Click on Online Tutorials, followed by How Do You Calculate a Company’s Cost of Capital?
• The TeachMeFinance website features several tutorial-type discussions that cover various aspects of financial management. For a cost-of- capital tutorial, go to www.teachmefinance.com and click on Cost of Capital in the list along the left side of the page.
408 Understanding Healthcare Finance Management
Notes
1. A question arises here as to whether the stated rate or the effective annual rate should be used in the cost-of-debt estimate. In general difference will be inconsequential, so most analysts opt for the easier ° approach, which is simply to use the stated rate. (The effective annual rate in this example is [1.0305]2 - 1.0 = 6.19% versus a 6.1 percent stated rate.) More important, most capital budgeting analyses use end of-year cash flows to approximate cash flows that occur throughout the year—in effect creating stated, as opposed to effective, cash flows. l'()r consistency, we prefer to use a cost of capital that does not recognize intra-year compounding—the cash flows will be understated, but so will the cost of capital.
2. Only a few firms in the health services industry use preferred stock financing, so we will not include preferred stock in our cost-of-capital examples. If preferred stock is used as a source of permanent financing it should be included in the cost-of-capital estimate, and its cost would be estimated using procedures similar to those discussed for the cost of debt.
3. See the Ibbotson SBBI2013 Classic Tearbook: Market Results for Stocks, Bonds, Bills, and Inflation 1926-2012 (Morningstar Inc., 2013) for a complete discussion of historical risk premiums, including a discussion of arithmetic and geometric averages.
4. See Blume, M. E. 1973. “Betas and Their Regression Tendencies.” Journal of Finance (June): 785-96. Merrill Lynch, for example, uses this formula: Adjusted beta = 0.34 + (0.66 x Historical beta).
5. A commercial provider of betas once admitted that his firm, and others, did not know what period to use but decided to use five years to reduce the apparent differences between various services’ betas; large differences reduced everyone’s credibility!
6. Log-linear regression is a standard time-series linear regression in which the data points are plotted as natural logarithms. The advantage of a log-linear regression is that the slope of the regression line is the average annual growth rate, assuming continuous compounding. In a standard time-series linear regression of EPS or DPS, the slope of the regression line is the average annual dollar change.
7. The calculation given in the text produces an arithmetic average growth rate. A better measure of average growth is the, geometric average growth rate, which is calculated as follows to be 7.0 percent:
Chapter 9: Cost of Capital 409
(1.12)5 x (1.065)45 = (1 + x)50
1.76234 x 17.01110 = (1 + x)50
29.97934 = (1 + x)50
1 + x = (29.97934)1/50
1 + x = 1.070
x = 0.070 = 7.0%.
The equation is asking: What annual growth rate in dividends over the entire 50-year period is equivalent to growth at 12 percent for 5 years, followed by growth at 6.5 percent for 45 years? The answer is an annual growth rate of 7.0 percent.
8. For one of the classic works on this topic, see Conrad, D. A. 1984. “Returns on Equity to Not-for-Profit Hospitals: Theory and
Implementation.” Health Services Research (April): 41-63. Also, see the follow-up articles by Pauly, Conrad, and Silvers and Kauer in the April 1986 issue of Health Services Research.
9. For an excellent discussion of this issue, see Cleverley, W. O. 1982. “Return on Equity in the Hospital Industry: Requirement or Windfall?” Inquiry (Summer): 150-59.
10. In theory, the cost of capital should also be adjusted when projects under evaluation have optimal capital structures that differ from the business’s target mix. Thus, if a project under evaluation by Ann Arbor had a debt capacity of 80 percent, versus 60 percent debt for the average project, this differential should be considered when evaluating the project. However, in reality, debt capacities for individual projects typically are impossible to estimate, so the adjustments made to the CCC usually are confined to risk differentials.
11. For more information on flotation cost adjustments, see Brigham, E. F., and M. C. Ehrhardt. 2013. “Chapter 9.” In Financial
Management: Theory and Practice, 14th ed. Mason, OH: South- Western Cengage Learning.
12. For more information on Hamada’s equation, see Hamada, R. S. 1969. “Portfolio Analysis, Market Equilibrium, and Corporation Finance.” Journal of Finance (March): 13-31.
4io Understanding Healthcare Finance Management
Integrative Application
The Problem
The director of capital budgeting for See-Saw Inc., manufacturer of orthopedic surgery tools, is considering a plan to expand production facilities to meet an increase in demand. She estimates that this expansion will produce a rate of return of 11 percent. The firm’s target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7 percent annual coupon rate. The bonds have a par value of $1,000 and are currently selling for $804. The firm has maintained a constant growth rate, E(g), of 6 percent. See-Saw’s next expected dividend, E(D), is $2 and its current stock price, Po, is $40. Its tax rate is 40 percent. See-Saw is considering funding its expansion with debt only, and any new debt will have a 25-year maturity. The director has to determine whether See-Saw should under- take the expansion.
The Analysis
The CCC sets the minimum return required on real-asset investments regard- less of the actual financing anticipated during the planning period. That is, even if See-Saw planned to finance all new capital investments with debt financing, the appropriate cost of capital is the CCC. The rationale is that the debt financ- ing cannot be obtained at the current cost rate without See-Saw’s equity bases, so from a financial perspective, the new capital investments are actually being financed using both equity and debt—that is, being financed at the firm’s target capital structure.
The cost of common equity can be estimated by the DCF:
E(Re) = E(Di)/Po + E(g)
E(Re) = $2 / $40 + .06 = 11%
The cost of debt can be estimated by the yield to maturity on the current debt:
=RATE(nper,pmt,pv,fv)
=RATE(25,$7O,-$8O4,$IOOO) = 8.99%
Chapter 9: Cost of Capital 411
In determining the capital structure weights, note that the debt/equity =
g, or 4/5 for “ample:
Debt
Equity
Debt + equity
4
5
9
Therefore, the capital structure weights are
Debt I (Debt + equity) 4 / 9 = 0.44
Equity / (Debt + equity) 5/9 = 0.56
The corporate cost of capital is
CCC = [wd x R(Rd) x (1 - T)] + [we x R(Re)] CCC = [0.44 x 8.99% x (1 - 0.4)] + [0.56 x 11%] CCC = 8.5%
The Decision
Since the expected rate of return is (11.0 - 8.5 =) 2.5 percentage points higher than the CCC, the director decided to undertake the expansion. Of course, the analysis assumed that the planned expansion of production facilities has the same risk as the average See-Saw project. If the project were of higher (lower) risk, the CCC would have had to be adjusted upward (downward). ■
CHAPTER SUPPLEMENT
MEASURING THE COST OF FUND CAPITAL
Supplement Learning Objectives After studying this chapter supplement, readers should be able to
• describe how Hamada’s equation can be used to measure the cost of fund capital, and
• discuss the limitations of using a for-profit firm’s cost of equity to set the opportunity cost inherent in the use of fund capital.
Measuring the Cost of Fund Capital
We have suggested that, at least in theory, the appropriate cost of equity capital to not-for-profit firms is the return available on the stocks of similar investor-owned firms. From our example in the chapter, the CAPM esti- mate for Ann Arbor Health Care is 13.5 percent, the DCF estimate is 13.8 percent, and the debt-cost-plus-risk-premium estimate is 14.0 percent. We concluded that there is sufficient consistency in the results to warrant the use of 13.8 percent, or thereabout, as the final estimate of the cost of equity for Ann Arbor. Thus, if Bayside Memorial Hospital and Ann Arbor are equiva- lent in all respects, we can use the 13.8 percent estimate for Ann Arbor’s cost of equity as our estimate for Bayside’s cost of fund capital. However, it is impossible to find identical investor-owned and not-for-profit firms because, even when they are in the same line of business and about the same size, they often use different amounts of debt financing and one is taxable and the other is not. Because of these dissimilarities, most theorists would argue that the cost estimate needs to be adjusted before it can be used by not-for-profit businesses.
The adjustment is accomplished by using Hamada’s equation, which was developed by Robert Hamada in 1969. Hamada combined the CAPM with Modigliani and Miller’s capital structure model, which we discuss in Chapter 10, to obtain the following equation:12
. x Assets
[l + [(l-T)x(D/£)]].
412
Chapter 9 Supplement: Measuring the Cost of Fund Capital 413
Here, bEquity is the market beta of the business’s stock; bAsscts is the inherent market beta of the assets, assuming that the business uses no debt financing; T is the tax rate; D is the market value of the business’s debt; and g is the market value of the business’s equity. In essence, bAssets measures the inherent market risk of the assets, and bEqujry measures the market risk of the assets when operated by a business with a given capital structure and tax rate.
In using Hamada’s equation, remember that the market beta of Ann Arbor’s stock is 1.50 and its tax rate is 40 percent. Also, Ann Arbor’s tar- get capital structure consists of 60 percent debt and 40 percent equity. If we assume that the firm is at, or close to, its target capital structure, these weights represent the firm’s current market value structure. To begin the adjustment, use Hamada’s equation to obtain the beta for hospital assets:
bAAHS = bA^x[l + [(l-T)x(D/E)]J 150 - bA„.„s * I* + K1 - 0-40) x (0.60 / 0.40)]]
1-50 = x 1.90
1-50/1.90 = 0.79.
C hapter 9 Supplem
ent
Now, if 0.79 is the inherent market beta of hospital assets, what is the implied beta of such assets when they are employed by Bayside, which uses 50 percent debt financing and is tax exempt? To find the answer, we must again use Hamada’s equation, but this time we know the asset beta and are solving for Bayside’s implied equity beta:
bBMH=bASSetSX[l+[(l-T)x(D/E)J]
= 0.79 x [1 + [(1 - 0) x (0.50 / 0.50)]]
= 0.79 x 2.0 = 1.58.
Finally, remembering that the risk-free rate is 6.0 percent and the required rate of return on the market is 11.0 percent, we can use the SML to estimate Bayside’s cost of equity capital:
R(R) = RF + [R(RJ - RF] x bBMH
= 6.0% + (11.0% - 6.0%) x 1.58
- 6.0% + (5.0% x 1.58) = 13.9%.
Because the tax rate difference is greater than the debt financing dif- ference, Bayside’s 13.9 percent cost of equity is somewhat greater than Ann Arbor’s 13.5 percent CAPM estimated cost of equity. Note that the cost
414 Understanding Healthcare Finance Management
of equity differential based on the CAPM method is 13.9% - 13.5% „ Q ' percentage points (40 basis points). Also, the final estimate for Ann Arbo ’ cost of equity is not 13.5 percent but rather 13.8 percent because all thr methods were considered in the final estimate. Thus, we could apply J 40-basis-points differential to the final estimate to obtain a cost-of-eo • estimate for Bayside of 13.8% + 0.4% = 14.2%.
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pt er
9 S
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t
Before closing this section, a few words of caution are in order \ |ot of issues cast doubt not only on the accuracy of the adjustment process just described but also on the entire concept of looking to a for-profit firm’s cost of equity to set the opportunity cost inherent in the use of fund capital. Here are just a few:
• The risk to an investor-owned firm’s stockholders is not the same as the risk to a not-for-profit business’s stakeholders. Stockholders are well-diversified investors regarding stock ownership, but stakeholders may not be so well diversified regarding their “investment” in not-for- profit businesses. The point here is that failure of one stock in a well- diversified investment portfolio has minimal impact on a typical equip' investor, but the failure of a not-for-profit business has a catastrophic impact on its stakeholders.
• In general, stock betas—and hence required rates of ROE—are available only for very large firms, and the risk inherent in the stock ownership of a large, well-diversified firm typically is less than the riskiness of the equity capital of a smaller, less-diversified business. For example, stock ownership of HealthSouth Corp.—which has more than 1,000 locations across the United States—even if held in isolation, is less risky than a stakeholder’s position in a single outpatient rehabilitation center. In effect, corporate diversification lowers risk, so the comparison of a widely diversified firm with a single enterprise is suspect.
• The use of Hamada’s equation is suspect because (1) there is no market value of a not-for-profit firm’s fund capital, so the market value of equity is not really defined for not-for-profit firms, and (2) the derivation of Hamada’s equation requires many unrealistic assumptions.
The bottom line here is that the entire process of estimating the cost of equity for not-for-profit businesses must be viewed with some skepticism- Nevertheless, the full opportunity cost estimate is the best that finance theory can muster, and developing a corporate cost of capital in this way is better, at least in our view, than ignoring the fact that there is an opportunity cost inherent in fund capital. One reaction to all the uncertainty involved in the
Chapter 9 Supplement: Measuring the Cost of Fund Capital 415
cstjination process might be to not use Hamada’s equation to refine the esti- mate. Rather, Just use Ann Arbor’s cost of equity, without adjustment, as a proxy f°r Bayside’s cost of fund capital. This simpler approach would pro- duce an estimate for Bayside’s cost of fund capital that is almost identical to the more complicated Hamada-adjusted estimate. Alternatively, if the entire opportunity cost process is unacceptable because of mission differences, the growth rate or rate required to maintain creditworthiness can be assigned.
1. What does Hamada’s equation attempt to do when it is used in the cost-of-equity estimation process?
2. What are some of the limitations of using a for-profit firm’s cost of equity to estimate the opportunity cost inherent in the use of fund capital?
Supplement Key Concepts This chapter supplement presents some background information on mea- suring the cost of fund capital. Here are its key concepts:
• Although the appropriate cost of equity capital to not-for-profit firms is the return available on the stocks of similar investor-owned firms, this is often difficult to achieve in practice.
• Hamada’s equation is used to estimate the cost of equity capital for a not-for-profit firm by adjusting for differences in debt financing and tax status.
• There are many issues that cast doubt on Hamada’s equation and the entire concept of looking to a for-profit firm’s cost of equity to estimate the opportunity cost of fund capital.
SELF-TEST QUESTIONS
C hapter 9 Supplem
ent
L_
k.naritK
CAPITAL STRUCTURE 10 Learning Objectives After studying this chapter, readers should be able to
• explain the effects of debt financing on a business’s risk and return, • briefly describe the primary capital structure theories and their
implications for managers, and • discuss the factors that influence the choice between debt and
equity financing.
Introduction
In Chapter 9, when we discuss a business’s corporate cost of capital, we note that the weights used in the calculation represent the optimal, or target, mix of debt and equity financing. These weights are defined by the capital struc- ture decision. We explain in this chapter that managers analyze a number of quantitative and qualitative factors and then establish the optimal, or target, capital structure for the business. Often, because of uncertainties in the esti- mation process, the target is expressed as a range rather than as a point value. The target will undoubtedly change over time as conditions internal and external to the business change, but at any given moment, managers have a specific capital structure in mind.
The target structure plays a major role in a business’s financing deci- sions. If less than the optimal amount of debt is on hand, new financings will be biased toward the use of debt. Conversely, if too much debt is on the books, equity will be the first choice for new capital. The key here is that one of the most important factors that influence financing decisions is the target capital structure. Managers prefer to finance in a way that keeps the business’s capital structure on target.
Once the optimal capital structure—and hence the optimal amount of debt—is identified, managers must consider the optimal maturity structure of the debt component. Should the business’s debt be all long term, all short term, or some combination of the two? This chapter addresses the optimal capital structure and optimal maturity structure decisions in detail.
418 Understanding Healthcare Finance Management
Impact of Debt Financing on Risk and Return
One of the most important concepts in capital structure decisions is th impact of debt financing on a business’s risk and return.1 The best way to present this concept is by illustration. Assume that a new business, Super Health, Inc., is being formed. The business requires $200,000 in assets to begin operation, and only two financing alternatives are available to it: (1) equity or (2) 50 percent debt and 50 percent equity.
Exhibit 10.1 contains the business’s projected starting balance sheet and first year’s income statement under the two financing alternatives To begin, consider the balance sheets shown in the top portion of the table The business will require $100,000 in current assets and $100,000 in fixed assets to begin operations. Because asset requirements depend on the nature and size of the business rather than on how the business will be financed, the asset side of the balance sheet is unaffected by the financing mix. However the capital, or claims, side of the balance sheet is influenced by the choice of financing. Under the all-equity alternative, the owners must put up the entire $200,000 needed to purchase the assets. If 50 percent debt financing is used, the owners will contribute only $100,000, and the remaining $100,000 will be obtained from creditors—say, a bank loan with a 10 percent interest rate.
EXHIBIT 10.1 Super Health,
Inc.: Projected Financial
Statements Under Two Financing
Alternatives
Balance Sheets
Current assets Fixed assets Total assets
Bank loan (io% cost) Total equity Total claims
Income Statements Revenues Operating costs
Operating income (EBIT) Interest expense
Taxable income Taxes (40%) Net income ROE Total dollar return
to investors
All Equity
$100,000
100,000 $200,000
$ 0 200,000
$200,000
$150,000 100,000
$ 50,000 ______0
$ 50,000 20,000
$ 30,000 15%
$ 30,000
Debt/Equity
$100,000 100,000
$200,000
$100,000 100,000
$200,000
$ 150,000 100,000 $ 50,000
10,000 $ 40,000
16,000 $ 24,000 _____24%
$ 34.°°°
Chapter 10: Capital Structure 419
Now, consider the impact of the two financing alternatives on Super Health’s projected income statement. First-year revenues are projected to be §150,000 and operating costs are forecasted at $100,000, so the business’s operating income—earnings before interest and taxes (EBIT)—is expected to be $50,000. Because the method of financing does not affect revenues and operating costs, the operating income projection is the same under both financing alternatives. However, interest expense must be paid if debt financ- ing is used, so the debt/equity alternative results in a 0.10 x $100,000 = $10,000 annual interest charge, while no interest expense occurs if the busi- ness is entirely financed with equity. The result is taxable income of $50,000 under the all-equity alternative and lower taxable income of $40,000 under the 50 percent debt alternative. Because the business anticipates being taxed at a 40 percent federal-plus-state rate, the expected tax liability is 0.40 x $50,000 = $20,000 under the all-equity alternative and 0.40 x $40,000 = $16,000 for the debt/equity alternative. Finally, when taxes are deducted from the income stream, Super Health projects a net income of $30,000 if it chooses all-equity financing and $24,000 if 50 percent debt financing is used.
At first glance, all-equity financing appears to be the best strategy. If the busi- ness uses 50 percent debt financing, its projected net income will fall by $30,000 - $24,000 = $6,000. But the conclu- sion that debt financing is bad requires closer examination. Business owners are less concerned with net income than with the return they expect on their equity investment. Perhaps the most meaningful measure of return to a business’s own- ers is the rate of return on equity, or just return on equity (ROE), which is defined as Net income/Total equity. Under all- equity financing, the projected ROE is $30,000/$200,000 = 0.15 = 15%. But with 50 percent debt financing, projected ROE increases to $24,000/$100,000 = 24%. The key here is that although net income decreases with debt financing, so does the amount of owner-supplied capi- tal, and the equity requirement decreases proportionally more than does net income.
Debt Use in the Healthcare Sector Capital structure theory has identified several factors as being important to the capital struc- ture decision. Two of the most important are the amount of business risk and the asset structure of the organization. Firms with greater business risk tend to use less debt financing, and firms with a large amount of brick-and-mortar assets, which can be used as loan collateral, tend to use more debt financing.
Now, consider three important healthcare industries: hospitals, medical equipment manu- facturers, and biotechnology companies. On average, which of these industries do you believe uses the most debt financing and which uses the least? Which industry sits in the middle?
What are your answers to these questions? How did you reach your conclusions? Does it make any difference if the hospitals are for-profit or not-for-profit? After you have your answers, you can go to http://biz.yahoo.com/ic/indjndex. html to see if you were right. Go to the healthcare section and click on hospitals to start. Industry statistics are listed in a box on the right side of the page—the next-to-bottom statistic (total debt/equity) measures the amount of debt financing.
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The end result is that the use of debt financing increases the expect, -d ROE. Why does this positive result happen? There is no magic here ip key is in the tax code: Interest expense is tax deductible for investor-owIlc j businesses, while dividend distributions are not. To understand the impact of the tax deductibility of interest, take another look at the income statements in Exhibit 10.1. The total dollar return to all investors, including owners and creditors, is $30,000 in net income if all-equity financing is used, but $24,000 in net income plus $10,000 of interest, for a total of $34,000, when 50 percent debt financing is used. Where did the “extra” $4,000 come frorrP The answer is, “from the tax man.” Taxes are $20,000 if Super Health is all- equity financed but only $16,000 when 50 percent debt financing is used and $4,000 less in taxes means $4,000 more for investors. Because debt financing reduces taxes, more of a business’s operating income (EBIT) is available for distribution to investors, including owners and creditors.
Super Health’s financing decision appears to be clear. Given only the two alternatives, Super Health should use the 50 percent debt alternative because it provides the owners with the higher return on investment. Unfor- tunately, like the proverbial no free lunch, there is a catch. The use of debt financing not only increases owners’ return but also increases their risk.
To understand the risk-increasing characteristics of debt financ- ing, consider Exhibit 10.2. Here, we recognize that Super Health, like all businesses, is risky. The owners do not know precisely what the first year’s revenues and operating costs will be. Assume, for illustrative purposes, that Revenues - Operating costs = Operating income can be as low as $0 or as high as $100,000 in the business’s first year of operations. Furthermore, assume that there is a 25 percent chance that the worst case will occur, a 25
EXHIBITION Super
Health, Inc.: Partial Income Statements in an Uncertain
World
All Equity_______ ________Debt/Equity
Probability 0.25 0.50 0.25 0.25 0.50 0.25 Operating income $0 $50,000 $100,000 $0 $50,000 $100,000
(EBIT) Interest expense 0 0 0 10,000 10,000 10,000
Taxable income $0
000o'LTl tn $100,000 ($10,000) $40,000 $ 90,000
Taxes (40%) 0 20,000 40,000 (4,000) 16,000 36,000 Net income $0 $30,000 $ 60,000 ($ 6,000) $24,000 $ 54.000
ROE 0% 15% 30% -6% 24% 54%
Expected ROE 15% 24% Standard deviation
of ROE 10.6% 21.2%
percent chance that the best case will occur, and a 50 percent chance that the Exhibit 10.1 forecast, with an operating income of $50,000, will be realized. The assumptions regarding uncertainty about the future profitability of the business lead to three different ROEs for each financing alternative. The expected ROEs are the same as when we ignored uncertainty—that is, 15 percent if Super Health is all-equity financed and 24 percent when 50 percent debt financing is used. However, the uncertainty in operating income produces uncertainty, and hence risk, in owners’ returns. If we measure own- ers’ risk by the standard deviation of ROE, we see that the return is more risky when 50 percent debt financing is used. More precisely, owners’ risk is twice as much in the 50 percent debt financing alternative: 21.2 percent standard deviation of ROE versus 10.6 percent standard deviation in the zero-debt alternative.
Intuitively, this risk increase occurs because the use of debt financing imposes a fixed cost—the $10,000 interest expense—on an uncertain income stream. In other words, the fixed interest payment must be made regardless of the level of operating income. The insertion of the fixed interest expense magnifies the variability of all values below the insertion point. Note that the increased risk is apparent without performing any standard deviation calculations. Under all-equity financing, the worst result is an ROE of zero. However, with 50 percent debt financing, the owners can realize an ROE of -6 percent. (Here, an assumption is made that the business’s $10,000 loss could be used to offset the owners’ personal income, resulting in a $4,000 tax savings. If this were not the case, the loss would be even worse.) In fact, with no operating income to pay the $10,000 interest due if the worst-case scenario occurs, the owners would have to either put up additional personal funds or declare the business bankrupt. Clearly, the use of 50 percent debt financing has increased the riskiness of the equity investment in the business. This simple example illustrates two key points about the use of debt financing:
1. The use of debt financing increases the percentage return (ROE) to a business’s owners. Note, however, that for the use of debt financing to increase owners’ returns, the basic (inherent) return on the business must be greater than the interest rate on the debt. The basic return on the business in the Super Health illustration is 25 percent ($50 in operating income divided by $200 in assets), and debt financing costs only 10 percent, so the use of debt financing increases ROE.
2. While the use of debt financing increases owners’ return, it also increases owners’ risk. In the Super Health example, we saw that 50 percent debt financing doubled the risk to owners (as measured by standard deviation of ROE).
Super Health’s ultimate decision regarding financial structure is not clear-cut. One alternative—no debt—has a lower expected ROE but also lower risk. The second alternative—50 percent debt—offers a higher expected ROE but only at the price of higher risk. To complicate matters even more, there are an almost unlimited number of debt-level choices avail- able to the business, not just the 50/50 mix used in the illustration. Later sections will try to resolve the dilemma facing Super Health, but first we need to introduce two other concepts.
SELF-TEST QUESTIONS 1. What is the impact of debt financing on a business’s risk and
return? 2. Why does the use of debt financing leverage up (increase) owners’
return?
Business and Financial Risk
In Chapter 5, we discuss several different dimensions of risk, including stand alone risk and portfolio (corporate and market) risk. Now, we introduce two new dimensions: (1) business risk and (2) financial risk. Here, the term finan- cial risk has a specific connotation—as opposed to its use in Chapter 5 where generically it means the risk arising from business transactions as opposed to other types of risk, such as risk to life and limb. Note that the concepts of business and financial risk apply just as much to not-for-profit businesses as they do to for-profit businesses, but in not-for-profits the risk concepts apply to the business’s non-creditor stakeholders, including the community at large, rather than to the business’s owners.
Business Risk Business risk is the inherent riskiness of a business as seen by its owners. It is measured by the uncertainty inherent in the business’s ROE, assuming that no debt financing is used. In other words, business risk is tire riskiness of a business’s assets, assuming they are all-equity financed. For an illustration of business risk, consider Santa Fe Healthcare, Inc., a debt-free, investor-owned hospital chain that operates in the southwestern United States. Exhibit 10.3 provides some insights into the firm’s business risk.
The top graph gives both security analysts and Santa Fe’s management an idea of the historical variability of ROE and, consequently, how the firm s ROE might vary in the future. This graph also shows that Santa Fe’s ROE is growing slowly, so the relevant variability of ROE is the dispersion about the trend line rather than the overall standard deviation of historical ROE. The
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Trend in Return on Equity (ROE)
ROE
Subjective Probability Distribution of ROE for 2014
EXHIBIT 10.3 Santa Fe Healthcare: Trend in ROE, 2004-2014, and Subjective ROE Distribution, 2014
Probability Density
bottom graph shows the beginning-of-year subjectively estimated probability distribution of Santa Fe’s ROE for 2014, based on the trend line in the top graph of Exhibit 10.3. As both graphs indicate, Santa Fe’s actual ROE in 2014 was only 8 percent, well below the expected value of 12 percent.
Santa Fe’s past fluctuations in ROE were caused by many factors— changes in the economy, actions by competing hospitals, changes in payer mix, changes in payment policies of third-party payers, changing labor costs, and so on. Similar events will undoubtedly occur in the future, and because
Understanding Healthcare Finance Management
they do, Santa Fe’s realized ROE will almost always be higher or lower than the projected level. Furthermore, there is always the possibility that some event that permanently depresses the company’s earning power might occur For example, the federal government could move to a single-payer system with dramatically reduced hospital reimbursement rates.
Because Santa Fe uses no debt financing, the uncertainty regarding its future ROE defines the firm’s business risk. The key point here is that we are trying to measure the riskiness of the business before it is influenced by the use of debt financing. Business risk varies not only from industry to industry but also among firms in a given industry. Furthermore, business risk can change over time. As mentioned in the previous chapter, hospitals were regarded for years as having little business risk, but events in the 1980s and 1990s—primarily the move of governmental payers to prospective pay- ment and the increasing bargaining power of managed care plans—greatly increased the industry’s business risk.
Business risk depends on a number of factors, including the following:
• Demand (volume) variability. The more stable the demand for a business’s products or services, other things held constant, the lower its business risk.
• Sales price variability. Businesses whose products or services are sold in markets with highly volatile prices are exposed to more business risk than are firms whose sales prices are more stable.
• Input cost variability. Businesses whose input costs—labor, materials, and capital—are highly uncertain are exposed to more business risk than are firms with more certain input costs.
• Ability to respond to changing market conditions. Some businesses are better able than others to respond to changing market conditions. For example, some hospitals are in a better position to raise their own prices when input costs rise. Other hospitals are more adept at cutting costs if the need arises. The greater the ability to respond to changing market conditions, the lower the degree of business risk, other things held constant.
• Liability exposure uncertainty. The greater the uncertainty in liability losses, the greater the business risk. For example, hospitals that perform a large number of high-risk surgeries face more liability risk than do hospitals with a limited surgery program.
• Operating leverage. Operating leverage measures the proportion of fixed costs, as opposed to variable costs, in a business’s cost structure. If a business has a high percentage of fixed costs, which by definition do not decline when demand falls off, it is exposed to a relatively high degree of business risk.
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of the factors that influence business risk is determined partly by industry characteristics, but each of them also can be influenced to some extent by managerial decisions. For example, consider operating leverage, higher fixed costs generally are associated with highly technical, capital- intensive businesses and industries. Thus, hospitals have higher fixed costs, relative to total costs, than do home health care agencies. Also, healthcare providers that employ highly skilled workers who must be retained and paid even during periods of low utilization have a relatively high proportion of fixed costs.
To what extent can businesses control their operating leverage? To a large extent, operating leverage is determined by industry characteristics. Firms such as drug manufacturers, hospitals, and ambulatory care clinics simply must make heavy investments in fixed assets and labor, which results in a high proportion of fixed costs and hence high operating leverage. On the other hand, firms such as home health agencies generally have signifi- cantly lower fixed-cost proportions and hence lower operating leverage. Still, although industry factors do exert a major influence, all businesses have some control over their operating leverage. For example, a hospital can expand its diagnostic imaging capability either by buying a new imaging device or by leasing it on a per procedure basis.2 If the hospital purchased the device, the hospital would incur fixed costs, but the device’s per procedure operating costs would be relatively low. If the hospital leased the device, the hospital would have lower fixed costs, but the variable—per procedure—costs for the device would be higher. Thus, by its financing decisions, and also by its capi- tal investment decisions, a business can influence its operating leverage and hence its basic business risk.
Financial Risk Financial risk is the additional risk placed on owners as a result of the deci- sion to use debt financing. Conceptually, a business has a certain amount of risk inherent in its operations—this is its business risk. However, the use of debt financing, or financial leverage., concentrates (increases) the risk seen by the business’s owners. Because the return to debt suppliers is fixed by contract and is independent of fluctuations in the business’s revenues and costs, creditors bear none of the firm’s business risk. For an illustration of this concept, consider the Super Health example. The business can be financed by either $200,000 of equity or $100,000 of equity and $100,000 of debt. The use of debt financing concentrates the business risk of the enterprise, which is fixed, on a smaller equity base and hence increases owners’ risk.
Business and financial risk can be easily measured. Refer again to Exhibit 10.2. The standard deviation of ROE to Super Health if it uses no debt financing—nROE(U), where U stands for unleveraged (no debt)—mea- sures its business risk. The standard deviation of ROE at any positive debt
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level—oROE (L), where L stands for leveraged (some debt)—measures the risk borne by owners. Because the use of debt financing concentrates the risk to owners, oROE (L) is always greater than oROE (U). Financial risk is the diffc ence between the actual risk seen by owners and the inherent business risk of the enterprise, or oROE (L) - oROE (U). Applying these measures to Super Health, we see that its business risk is oROE (U) = 10.6% and its risk under 5o percent debt financing is oROF (L) = 21.2%, so the financial risk at that level of debt is oROE (L) - oROB (U) = 21.2% - 10.6% = 10.6%.
Operating leverage and financial leverage normally work in the same way; they both increase expected ROE, but they also increase the risk borne by owners. Operating leverage affects the business risk of the enterprise while financial leverage affects its financial risk.
SELF-TEST QUESTIONS 1. What is business risk? How can it be measured?
2. What are some determinants of business risk? 3. What is operating leverage? 4. What is financial risk? How can it be measured? 5. What are the similarities between operating leverage and financial
leverage?
Capital Structure Theory
The preceding discussion points out that the use of debt financing increases the expected ROE, but from the perspective of the business’s owners, it also increases the risk of the business. The obvious question now is whether the benefit of debt financing (increased expected return) exceeds the cost of debt financing (increased risk). Capital structure theory attempts to determine the relationship between the amount of debt financing and the value of a business; thus, its goal is to determine, after risk is considered, whether the use of finan- cial leverage is beneficial. The theory is directly applicable to investor-owned businesses, but it also provides some guidance for not-for-profit businesses. Although capital structure theory does not provide a complete answer to the optimal capital structure question, it does provide many insights into the value of debt financing versus equity (or fund) financing. Thus, an understanding of capital structure theory will aid managers in making capital structure decisions.
The Modigliani-Miller Models Until 1958, capital structure theories were little more than loose assertions about investor behavior rather than carefully constructed models that could be tested by formal statistical studies. In what has been called the most influ- ential set of financial papers ever published, Franco Modigliani and Merton
(MM) addressed the capital structure issue in a rigorous, scientific fashion and set off a chain of research that continues to this day.3
Assumptions To begin, MM made the following assumptions, some of which were later
relaxed:
• The business risk of an enterprise can be measured by the standard deviation of earnings before interest and taxes (oEBIT). Firms with the same degree of business risk are said to be in a homogeneous risk class.
• All present and prospective investors have identical estimates of each firm’s future EBIT—that is, investors have homogeneous expectations about expected future corporate earnings and the riskiness of those earnings.
• Stocks and bonds are traded in perfect capital markets. This assumption implies, among other things, that there are no brokerage costs and that investors—both individual and institutions—can borrow at the same rate as corporations.
• The debt of businesses and individuals is riskless., so the interest rate on debt is the risk-free rate. Furthermore, this situation holds regardless of how much debt a business, or an individual, uses.
• All cash flows are perpetuities—that is, businesses are assumed to have zero growth with an “expectationally constant” EBIT, and its bonds are perpetuities. Expectationally constant means that investors expect EBIT to be constant, but the realized, or after the fact, value in any year can be different from the expected level.
MM Without Taxes MM first performed their analysis under the assumption that there are no corporate or personal income taxes. On the basis of the preceding assump- tions, and in the absence of taxes, they proposed and then algebraically proved two propositions:4
Proposition I The value of any business, V, is established by discounting its expected net operating income (EBIT when T = 0) at a constant rate that is appropriate for its risk class, regardless of the amount of debt financing used:
Key Equation 10.1: Value of a Firm Assuming No Taxes
428 Understanding Healthcare Finance Management
Here, the subscripts L and U designate levered (with debt finan ' and unlevered (without debt finan eng) businesses in a given risk class CCC is the corporate cost of capital, and R(ReU) is the required rate of return equity for an unlevered (zero debt) business. The key point here is that th discount rate used to determine the value of the business is a constant—-CCC = R(ReU)—regardless of the amount of debt financing used, and because EBIT is unaffected by debt financing, the value of the business also is a constant
Because V, as established by Proposition I, is a constant regardless of the level of debt financing, under the MM model with no taxes, the value of a business is independent of its leverage. This statement also implies that (1) the CCC to any business is completely independent of its capital structure and (2) the CCC for all businesses with the same business risk (in the same risk class) is equal to the cost of equity to an unlevered firm in that risk class, regardless of the amount of debt financing used.
Proposition II The cost of equity to a levered firm, R(ReL), is equal to (1) the cost of equity to an unlevered firm in the same risk class, R(RcU), plus (2) a risk premium that depends on both the differential between the costs of equity and debt to an unlevered firm and the amount of leverage used:
Key Equation 10.2: Cost of Equity to a Levered Firm Assuming No Taxes
R(R 1) = R(R v) + Risk premium = R(RcU) + {[R(RcU) - R(Rd)] x (D / E)}.
Here, D = the market value of the business’s debt, E = the market value of the business’s equity, and R(Rd) = the constant cost of debt. Proposi- tion II states that as a business’s use of debt increases, its cost of equity also increases, in a mathematically precise manner.
Taken together, the two MM propositions imply that the inclusion of debt in a business’s capital structure will not increase its value because the benefits of the less costly debt financing (as compared to equity financing) will be exactly offset by an increase in the riskiness, and hence in the cost, of the business’s equity. Thus, MM theory implies that in a world without taxes, both the value of a firm and its CCC are unaffected by its capital structure.
MM used an arbitrage proof to support their propositions.5 They showed that, under their assumptions, if two firms differed only (1) in the way they are financed and (2) in their total market values, investors would sell shares of the higher-valued firm, buy those of the lower-valued firm, and continue this process until the firms had exactly the same market value. Thus, the actions of investors would ensure that the two firms had identical market
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1 -c Once the values are proved to be equal, the two MM propositions values- are the logical result.6
Note that each of the assumptions listed in the beginning of this sec- tion is necessary for the arbitrage proof to work. For example, if the firms are not identical in business risk, the arbitrage process cannot be invoked. We will discuss further implications of the assumptions later in the chapter.
MM with Corporate Taxes MM’s original work, published in 1958, assumed zero taxes. In 1963, MM
published a second article that included corporate tax effects. With corpo- rate income taxes, the authors concluded that the use of financial leverage will increase a business’s value. When businesses are subject to income taxes, the MM propositions are as follows.
Proposition I The value of a levered firm is equal to (1) the value of an unlevered firm in
the same risk class plus (2) the gain from leverage, which is the present value of the tax savings and which equals the corporate tax rate, T, multiplied by the amount of debt the firm uses, D:7
Key Equation 10.3: Value of a Levered Firm with Corporate Taxes
VL = VU + (TXD).
The important point here is that, when corporate taxes are introduced, the value of a levered business exceeds that of a similar unlevered business by the amount T x D. Note also that the differential increases as the use of debt increases, so a business’s value is maximized at virtually 100 percent debt financing.
To find the MM value for VG for any business, recognize that all busi- nesses are assumed to have zero growth and a constant EBIT, and all earnings are paid out as dividends. Thus, the total market value of a business’s equity, E, can be found using perpetuity valuation techniques as follows:
P Dividends Net income {EBIT - [R(Rd) xD]}x(I - T) R(RC) = R(Re) ’ R(Re)
With zero debt, D = $0 and the total value of the firm is its equity value, so
Key Equation 10.4: Value of Unlevered Firm with Corporate Taxes EBITx(l -T)
R(Reu)
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Proposition II
The cost of equity to a levered firm is equal to (1) the cost of equity to unlevered firm in the same risk class (equal business risk) plus (2) a risk prc mium that depends on the differential between the costs of equity and debt to an unlevered firm, the amount of financial leverage used, and the corpo rate tax rate:
Key Equation 10.5: Cost of Equity to a Levered Firm with Corporate Taxes
R(ReL) = R(ReU) + Risk premium = R(ReU) + |[R(ReU) - R(Rd)] x (1 - T) x (D / E)}.
Notice that Proposition II here is identical to the corresponding without-tax equation, except for the term (1 - T). Because (1 - T) is less than 1.0 for any positive tax rate, the imposition of corporate taxes causes the cost of equity to rise at a slower rate when debt is used than it did in the absence of taxes. It is this characteristic, along with the fact that the effective cost of debt is reduced because of the tax deductibility of interest, that produces the Proposition I result—namely the increase in firm value as leverage increases.
Illustration of the MM Models For an illustration of the MM models, assume that the following data and conditions hold for New England Clinical Laboratories, Inc., an old, estab- lished firm that operates in several no-growth areas in rural Maine, New Hampshire, and Vermont:
• New England currently has no debt; it is an all-equity firm. • Expected EBIT = $2.4 million. EBIT is not expected to increase over
time, so New England is in a no-growth situation. • New England pays out all of its income as dividends because no
retained earnings are required to finance growth. (Worn-out assets are replaced using depreciation cash flow.)
• If New England begins to use debt, it can borrow at a rate R(Rd) = 8%. This borrowing rate is constant, and it is independent of the amount of debt used. Any money raised by selling debt would be used to retire common stock, so New England’s assets and EBIT would remain constant.
• The risk of New England’s assets, and thus its EBIT, is such that its shareholders require a rate of return, R(RcU), of 12 percent if no debt is used.
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To begin, assume that there are no taxes, so T = 0%. At any level of debt, proposition I can be used to find New England’s value, $20 million:
vL = vu EBITR(RcU) $2.4 million
0.12 = $20.0 million.
With zero debt, the $20 million represents all-equity value. Now, assume that New England decides to use $10 million of debt financing. According to Proposition I, its total value will not change, so the business’s equity value must fall to $10 million:
E = V - D = $20 million - $10 million = $10 million.
This decrease occurs because the $10 million of new debt financing is used to repurchase $10 million of existing equity.
We can also find New England’s cost of equity, R(R L), and its CCC at a debt level of $10 million. First, we use Proposition II to find R(RcL), New England’s levered cost of equity:
R(RL) = R(ReU) + {[R(ReU) - R(Rd)] x (D / E)}
= 12% + {[12% - 8%] x ($10 million / $10 million))
= 12% + 4.0% = 16.0%.
Now, we can find the firm’s CCC:
CCC = [Wd X R(Rd) X (1 - T)] + [We X R(RJ]
= [($10 / $20) x 8% x 1.0] + [($10 / $20) x 16.0%] = 12.0%.
We can easily expand the illustration to show New England’s value and CCC at various debt levels. We would see that in an MM world without taxes, financial leverage does not matter: The value of the firm and its overall cost of capital are independent of the amount of debt financing used. The key to this result is that the additional risk imposed by the use of debt financing increases the cost of equity just enough to counteract any benefit that results from the fact that debt costs are lower than equity costs. In essence, each of these security classes is priced—has a required rate of return—such that the business is indifferent to the choice. Debt costs less than equity, but to the business it is a riskier form of financing than equity. Thus, each type of capital 1S priced correctly on the basis of the risk it brings to a business, so the financ- ing mix does not affect the value of the firm.
I.
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With Corporate Taxes For an illustration of the MM model with corporate taxes, assume that all the previous assumptions hold except these two:
1. Expected EBIT = $4 million. 2. New England has a 40 percent federal-plus-state tax rate, so T = 40%
Note that we increased New England’s EBIT from $2.4 million to S4 million to make the numerical comparison between the two models easier If we had not, the introduction of corporate taxes would lower New Eng- land’s value by Expected EBIT x (1 - T) = $2.4 million x 0.6 = $1.44 million.
When New England has zero debt but pays taxes, and its expected EBIT is increased to $4 million, its value with zero debt financing is $20 million:
EBIT x (I - T) $4 million x 0.6 R(ReU) ' 0.12
= $20.0 million.
With $10 million of debt in a world with taxes, Proposition I indicates that New England’s total market value rises to $24 million.
VL = Vy + (T x D) = $20 million + (0.4 x $10 million) = $24 million.
Therefore, the value of New England’s equity must be $14 million:
E = VL- D = $24 million - $10 million = $14 million.
To find New England’s cost of equity and its CCC at a debt level of $10 million, we first use Proposition II to find the levered cost of equity:
R(ReL) = R(ReU) + {[R(ReU) - R(Rd)] x (1 - T) x (D / E)}
= 12% + [(12% - 8%) x 0.6 x ($10 million / $14 million)]
= 12% + 1.71%= 13.71%.
Then, we can find the firm’s weighted average cost of capital:
CCC = [Wd X R(Rd) X (1 - T)] + [we X R(RL)]
= [($10 / $24) x 8% x 0.6] + [($14 / $24) x 13.71%] = 10.0%.
Again, we can easily expand the illustration to include additional debt levels. We see that in an MM world with corporate taxes, financial leverage
does matter: The value of the firm is maximized and its overall cost of capital js minimized if it uses virtually 100 percent debt financing. Furthermore, we ^ow that the increase in value solely results from the tax deductibility of interest payments, which causes both the cost of debt and the increase in the cost of equity with leverage to be reduced by (1 - T). With tax deductibility of interest payments, the cost of debt is now less than that warranted by the risk it brings to a business; hence, businesses prefer debt to equity, which remains fairly priced in relationship to the risk it brings to a business.
1. What is the single most important conclusion of the MM zero-tax model?
2. What is the single most important conclusion of the MM model with corporate taxes?
3. What is the underlying cause of the “gain from leverage” in the MM model with corporate taxes?
SELF-TEST QUESTIONS
The Miller Model
Although MM included corporate taxes in the second version of their model, they did not extend the model to analyze the effects of personal taxes. However, Merton Miller later introduced a model designed to show how leverage affects firms’ values when both personal and corporate taxes are taken into account.8 To explain Miller’s model, let us begin by defining T as the corporate tax rate, T as the personal tax rate on equity returns, and Td as the personal tax rate on debt returns. Note that equity returns typically come partly as dividends and partly as capital gains, so T is a weighted average of the effective tax rates on dividends and capital gains, while essentially all debt income comes from interest, which is taxed at investors’ top rates.
With personal taxes included, and under the remaining assumptions used in the earlier MM models, the value of an unlevered firm is found by the following equation:
On the web at: ache.org/books/ UHFM7
Key Equation io.6: Value of Unlevered Firm with Corporate and Personal Taxes
EBITx(l-Tc)x(l-Te) u R(RtU)(l-Te)
Note that Equation 10.6 is the same as Equation 10.4, except for die addition of the (1 - T) term, which adjusts for personal taxes. Now, the
434 Understanding Healthcare Finance Management
numerator shows how much of a business’s operating cash flow is availabl investors after the unlevered firm itself pays corporate income taxes and equityholders subsequently pay personal taxes on the equity income In efifeLJ the numerator is the perpetual after-all-taxes cash flow stream to equity iny tors. Because the denominator is the after-tax return on equity, the (1 T- term cancels out and we are left with Equation 10.4. Therefore, personal taxel do not change the value of the unlevered firm, other things held constant
The Miller model, which can be derived using an arbitrage proof simi lar to the one used to prove the MM models, is as follows:
Key Equation 10.7: Value of a Levered Firm with Corporate and Personal Taxes
vL = vu + (1 - Tc) x (1 - Tc)1-Td
Here are some relevant points about the Miller model:
• The term bracketed by [ ], when multiplied by D, is the new gain from leverage. It replaces T = T in the earlier MM model with corporate taxes.
• If we ignore all taxes (i.e., if T = T = Td = 0), the bracketed term reduces to zero, so, in that case, the Miller model is the same as the original MM model without taxes.
• If we ignore personal taxes (i.e., if T = T( = 0), the bracketed term reduces to T, so the Miller model reduces to the MM model with corporate taxes.
• If the effective personal tax rates on stock and bond incomes were equal (i.e., if T = Td), the bracketed term would again reduce to T.
• If (1 - T) x (1 - T ) = 1 - Td, the bracketed term would go to zero and the value of using leverage would also be zero. This result implies that the tax advantage of debt to the firm would be exacdy offset by the personal tax advantage of equity. Under this condition, capital structure would have no effect on a firm’s value or its cost of capital, so we would be back to MM’s original zero-tax theory.
Because the tax rate on dividends and capital gains is less than the tax rate on ordinary income (generally 15 percent versus 28, 33, or 35 percent), and because taxes on capital gains are deferred, the effective tax rate on equity income is less than the effective tax rate on debt income.9 This being
Chapter 10: Capital Structure 435
i me what would the Miller model predict as the gain from leverage? To the casv, . . answer this question, assume that the tax rate on corporate income is lc = 34% the effective rate on bond income is Td = 36%, and the effective rate on tock income is T = 10%. Using these values in the Miller model, we find that a levered firm’s value increases over that of an unlevered firm by 7 percent of the market value of corporate debt:
Gain from leverage = xD1 -
1 - 1 -0.36 = [1 - 0.93] x D = 0.07 x D.
xD
Note that, with these data, the MM model with corporate taxes would indicate a gain from leverage of T x D = 0.34 x D, or 34 percent of the amount of corporate debt. Thus, with these assumed tax rates, the addi- tion of personal taxes to the model significantly lowers the benefit derived from corporate debt financing. In general, whenever the effective tax rate on equity income is lower than the effective rate on debt income, the Miller model produces a lower gain from leverage than that produced by the MM with corporate taxes model. The fact that personal tax rates favor equity investments means that interest rates must be higher (than in the absence of personal taxes) on corporate debt financing to attract debt capital. These higher interest rates reduce the value of debt financing to businesses and hence lower the gain from leverage.
In his paper, Miller argued that firms in the aggregate would issue a mix of debt and equity securities such that the before-tax yields on corporate securities and the personal tax rates of the investors who bought these secu- rities would adjust until equilibrium was reached. At equilibrium, (1 - Td) would equal (1 - T) x (1 - T), so, as we noted earlier, the tax advantage of debt to the firm would be exactly offset by personal taxation and capital structure would have no effect on a firm’s value or its cost of capital. Thus, according to Miller, the conclusions derived from the original MM zero-tax model are correct!
Others have extended and tested Miller’s analysis. Generally, these extensions disagree with Miller’s conclusion that there is no advantage to the use of corporate debt. In the United States, the effective tax rate on equity income is lower than the effective tax rate on debt income, so it appears that there is an advantage to the corporate use of debt financing. However, Miller’s work does show that personal taxes offset some of the benefits of cor- porate debt, so the tax advantages of corporate debt probably are fewer than those implied by the earlier MM model that considered only corporate taxes.
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SELF-TEST QUESTIONS 1. How does the Miller model differ from the MM model with
corporate taxes? 2. What are the implications of the Miller model under various tax
assumptions? 3. What is the primary implication of the Miller model given the
current tax situation in the United States?
Criticisms of the MM and Miller Models
The conclusions of each of the three models follow logically from their initial assumptions: If the assumptions are correct, the resulting conclusions must be reached. However, academics and managers have voiced concern over the validity of these models, and virtually no businesses follow the recom- mendations of any of the models. Use of the MM zero-tax model leads to the conclusion that capital structure does not matter, but we observe some regularities in structure within industries. Furthermore, when used with “rea- sonable” tax rates, use of both the MM model with corporate taxes and the Miller model lead to the conclusion that firms should use 100 percent debt financing. That situation is not observed in practice except by firms whose equity has been eroded by operating losses. Those who disagree with the MM and Miller models and their suggestions for financial policy generally attack the models on the grounds that their assumptions do not reflect real- world conditions. Some of the main objections include the following:
• MM and, later, Miller assume that personal and corporate leverage are perfect substitutes. However, an individual investing in a levered firm has less loss exposure, and hence more limited liability, than if he used “homemade” leverage by taking on personal debt. This increased personal risk exposure would tend to restrain investors from engaging in the type of arbitrage required to derive the models, and impeded arbitrage can cause the models to be incorrect.
• Brokerage costs were assumed away in the MM and Miller models. However, brokerage and other transaction costs do exist, and they too impede the arbitrage process.
• MM initially assumed that both businesses and individual investors can borrow at the risk-free rate. Although risky debt has been introduced into the analysis by others with no significant change in results, it is still necessary to assume that both corporations and investors can borrow at the same rate to reach the MM and Miller conclusions. Although major institutional investors probably can borrow at the corporate
Chapter 10: Capital Structure
rate, many institutions are not allowed to borrow to buy securities. Furthermore, most individual investors must borrow at higher rates than those paid by large corporations.
• The MM and Miller models assume that there are no costs associated with financial distress. These costs are discussed in the next section.
1. Should we accept one of the models presented thus far as being correct? Why or why not?
2. In your view, which of the assumptions used in the models is most likely to invalidate them?
SELF-TEST QUESTIONS
Financial Distress Costs
Some of the assumptions inherent in the MM and Miller models can be relaxed, and when this is done, their basic conclusions remain unchanged. However, as we discuss next, when financial distress costs are added, the MM and Miller results are altered significantly.
A number of firms experience financial distress each year, and some of them are forced into bankruptcy. Financial distress includes, but is not restricted to, bankruptcy, and when it occurs, several things can happen, including the following:
• Arguments between claimants often delay the liquidation of assets. Bankruptcy cases can take many years to settle, and during this time equipment loses value, buildings are vandalized, inventories become obsolete, and so on.
• Lawyer’s fees, court costs, and administrative expenses can absorb a large part of a business’s value. Together, the costs of physical deterioration plus legal fees and administrative expenses are called the direct costs of bankruptcy.
• Managers generally lose their jobs when a firm fails. Knowing this, the managers of a business in financial distress often take actions that keep it alive for the short run but dilute its long-run value. For example, a hospital in financial distress may fail to modernize or may sell off valuable nonessential assets at bargain prices to raise cash or cut costs so much that it impairs the quality of its services and erodes its long- run market position.
• Stakeholders of organizations experiencing financial difficulties are aware of the problems and often take actions that further damage troubled firms. For example, patients may go elsewhere, suppliers
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may be reluctant to sell on credit, and medical staff may be difficult to recruit and retain. Suboptimal managerial actions associated with financial distress, as well as the costs imposed by stakeholders, are called the indirect costs of financial distress. Of course, a business in financial distress may incur these costs even if it does not go into bankruptcy; bankruptcy is just one point in the continuum of financial distress.
All things considered, the direct and indirect costs associated with financial distress are high, but financial distress typically occurs only if a firm uses debt financing because debt-free businesses rarely experience financial distress. Therefore, the greater the use of debt financing, and the larger the fixed interest charges, the greater the probability that a decline in earnings will lead to financial distress and, hence, the higher the probability that costs of financial distress will be incurred.
An increase in the probability of incurring financial distress raises a firm’s cost of equity capital and hence lowers the current value of the firm’s equity. Furthermore, the probability of incurring financial distress increases with leverage, causing the expected present value cost of financial distress to rise as more and more debt financing is used. A firm’s creditors also feel the effects of financial distress. Businesses that experience financial distress have a higher probability of defaulting on debt payments, so the expectation of financial distress influences creditors’ required rates of return: the higher the probability of incurring financial distress, the higher the required return on debt. Thus, as a firm uses more and more debt financing and hence increases the probability of incurring financial distress, its cost of debt also increases.
SELF-TEST QUESTIONS 1. Describe some financial distress costs.
2. How are financial distress costs related to the use of financial leverage?
Trade-Off Models
Both the MM with corporate taxes and Miller models as modified to reflect financial distress costs are described as trade-off models—that is, the optimal capital structure is found, at least conceptually, by balancing the tax shield benefits of leverage against the financial distress costs of leverage, so the costs and benefits are “traded off’ against one another.
Model Structure If the MM model with corporate taxes were correct, a firm’s value would rise continuously as it moved from zero debt toward 100 percent debt: The
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equation Vr = Vv + (T x D) shows that T x D (hence Vr) is maximized if D is at a maximum. Recall that the rising component of value, T x D, results directly from the tax shelter provided by interest on the debt. However, the present value of the costs associated with potential future financial distress would cause V, to decline as the level of debt increases. Therefore, in the with corporate taxes model, the relationship between a firm’s value and its use of leverage takes this form when financial distress costs are added:
Key Equation 10.8: Value of a Levered Firm with Financial Distress
Vj = VL, + (T x D) - PV of expected financial distress costs.
The relationship expressed in this equation is graphed in Exhibit 10.4. The tax shelter effect dominates until the amount of debt reaches Point A. After Point A, financial distress costs become increasingly important, offset- ting some of the tax advantages. At Point B, the marginal tax shelter benefits of additional debt are exactly offset by the marginal disadvantages of debt, and beyond Point B, the marginal disadvantages outweigh the marginal benefits.
The Miller model can also be modified to reflect financial distress costs. The equation would be identical to that developed for the MM with corporate taxes model, except that the gain-from-leverage term, T x D, would be adjusted to reflect the addition of personal taxes. In either the MM
Value of Firm, V
EXHIBITION Net Effect of Financial Leverage on the Value of the Firm
E
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or Miller models, the gain from leverage can at least be roughly estimated but the value reduction resulting from potential financial distress costs is almost entirely subjective. We know that these costs must increase as the use of debt financing rises, but we simply do not know the specific functional relationship.
Model Implications The trade-off models are not capable of specifying precise optimal capita] structures, but they do enable us to make three statements about debt usage-
1. Higher-risk businesses, as measured by the variability of returns on the business’s assets, ought to borrow less than lower-risk firms, with other things being equal. The greater this variability, the greater the probability of financial distress at any level of debt and, hence, the greater the expected costs of distress. Thus, firms with lower business risk can borrow more before the expected costs of distress offset the tax advantages of borrowing.
2. Businesses that employ tangible assets, such as real estate and standardized equipment, should borrow more than firms whose value is derived either from intangible assets, such as intellectual capital and goodwill, or from growth opportunities. The costs of financial distress depend not only on the probability of incurring distress but also on what happens if distress occurs. Specialized assets, intangible assets, and growth opportunities are more likely than standardized, tangible assets to lose value if financial distress occurs.
3. Businesses that are currently paying taxes at the highest rate, and that are likely to continue to do so in the future, should carry more debt than should firms with current and/or prospectively lower tax rates. High corporate tax rates lead to greater benefits from debt financing; hence, high-tax-rate firms can carry more debt, other factors held constant, before the tax shield is offset by financial distress costs.
According to the trade-off models, each business should set its target capital structure such that its costs and benefits of leverage are balanced at the margin because such a structure will maximize its value. We would expect to find actual target structures that are consistent with the three points just noted. Furthermore, we would generally expect to find that firms in an industry have similar capital structures because such firms have roughly the same types of assets, business risk, and profitability.
The Empirical Evidence The trade-off models have intuitive appeal because they lead to the conclu- sion that both no debt and all debt are bad, while a “moderate” debt level
Chapter 10: Capital Structure
js good. However, we must ask ourselves whether these models explain actual behavior. If they do not, we must search for other explanations or assume that managers, and hence investors, are acting irrationally, which is an assumption that we are unwilling to make.
The trade-off models do have some empirical support.10 For example, businesses that have primarily tangible assets tend to borrow more heavily than do firms whose value stems from intangibles and/or growth opportuni- ties. However, other empirical evidence refutes the trade-off models. First, several studies have examined models of financing behavior to see whether firms’ financing decisions reflect adjustment toward a target capital structure. These studies provide some evidence that they do, but the explanatory power of the models is low, suggesting that trade-off models capture only a part of actual behavior. Second, no study has clearly demonstrated that a firm’s tax rate has a predictable, material effect on its capital structure. In fact, firms used debt financing long before corporate income taxes even existed. Finally, actual debt ratios tend to vary widely across apparently similar firms, whereas the trade-off models suggest that the use of debt should be relatively consis- tent within industries.
All in all, empirical support for the trade-off models is not strong, which suggests that other factors not incorporated into these models are also at work. In other words, the trade-off models do not tell the full story.
1. What is a trade-off model of capital structure? 2. What are the implications of the trade-off models for capital
structure decisions? 3. Does empirical evidence support the trade-off models?
SELF-TEST QUESTIONS
Asymmetric Information Model of Capital Structure
The asymmetric information model of capital structure traces back to the work done in the 1960s by Gordon Donaldson.11 Donaldson conducted an extensive survey of investor-owned corporations to find out how managers make financing decisions and reached the following conclusions:
• Businesses prefer to finance with internally generated funds—that is, with retained earnings and depreciation cash flow.
• Businesses set target dividend payout ratios on the basis of their expected future investment opportunities and their expected future cash flows. The target payout ratio is set at a level such that expected retentions plus depreciation cash flow will meet expected capital expenditure requirements.
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Dividends are “sticky” in the short run because firms are reluctant to make major changes in the dollar dividend, and they are especially reluctant to cut the dividend. Thus, in any given year, depending On realized cash flows and actual investment opportunities, a business or may not have sufficient internally generated funds to cover its capital expenditures.
• If a business has more internal cash flow than is needed for capital investment, it will invest the excess in marketable securities or use the funds to retire debt.
• If a business has insufficient internal cash flow to finance its capital investments, it will first draw down its marketable securities portfolio then issue debt, then issue convertible bonds—bonds that can be exchanged in the future for common stock—and then only as a last resort will it sell new equity.
Thus, Donaldson observed a “pecking order” of financing, not the balanced approach that is called for by the trade-off models. Indeed, the pecking order causes firms to move away from, rather than toward, a well- defined capital structure because equity hinds are raised in two forms: (1) retained earnings at the top of the pecking order and (2) new common stock sales at the bottom.
For many years, no theoretical model was available to explain this behavior, so academics did not give Donaldson’s survey results much cre- dence. Then, Stewart C. Myers proposed the asymmetric information model of capital structure.12 The model is based on two assumptions: (1) Manag- ers know more about their firm’s future prospects than do investors, and (2) managers are motivated to maximize the wealth of their firm’s current shareholders.
If managers think that their firm’s equity is undervalued, they will be motivated to use debt financing because selling stock at a “bargain” price is detrimental to the firm’s existing shareholders. However, if managers think that their firm’s equity is overvalued, they will be motivated to issue new common stock. By issuing stock for more than it is actually worth, manag- ers transfer value from the buyers of the new stock to existing shareholders. Thus, managers are motivated to issue new stock only when they believe that the stock is overvalued. Because equity investors are rational, they treat new common stock issues as “signals” that management considers the stock to be overvalued. Thus, investors revise their expectations for the firm downward and the stock price falls.13
Because new equity issues have an adverse effect on stock price, man- agers are reluctant to issue new stock. Although large amounts of new stock are issued each year, the vast majority is issued by small, rapidly growing firing that have large capital needs and hence little choice. Equity issues by mature
firms are relatively rare. If external financing is required, debt is the first choice and new common stock will be used only in unusual circumstances. Thus, the asymmetric information model leads managers to act in accordance with Donaldson’s pecking order.
Because managers want to avoid issuing new stock, especially when jt might be least advantageous, it becomes prudent for firms to maintain a reserve borrowing capacity that can be used whenever capital investments require an unusually large amount of external capital. By maintaining a reserve borrowing capacity and then tapping it when necessary, managers can avoid issuing new common stock under unfavorable conditions.
Note that the degree of information asymmetry and its impact on investors’ perceptions differ substantially across firms. For example, the degree of asymmetry is typically much greater in the pharmaceutical industry than in the hospital industry because success in the drug industry depends on secretive proprietary research and development. Thus, managers in the drug industry hold significantly more information about their firm’s prospects than do outside analysts and investors. Also, start-up businesses with limited capital and good growth opportunities are recognized for having to use external financing, so investors do not view new stock offerings by such firms with as much concern as they view new offerings by mature firms with limited growth opportunities. Thus, although the asymmetric information theory is applicable to all investor-owned firms, its influence on managerial decisions varies from firm to firm and over time.
1. Briefly explain the asymmetric information model of capital structure.
2. What does the model suggest about capital structure decisions?
SELF-TEST QUESTIONS
Summary of the Capital Structure Models
The great contribution of the trade-off models of MM, Miller, and their followers is their ability to identify the specific benefits and costs of using debt—the tax effects, financial distress costs, and so on. Before these models were developed, no capital structure theory existed and we had no systematic way of analyzing the effects of debt financing.
The trade-off model is summarized in Exhibit 10.5. The top graph shows the relationships between the debt ratio and the cost of debt, cost of equity, and the CCC. Both the cost of equity and the effective (after-tax) cost of debt rise steadily with increases in leverage, but the rate of increase accel- erates at higher debt levels, reflecting the increased probability of incurring financial distress and its attendant costs. The CCC first declines, then hits a
444 Understanding Healthcare Finance Management
minimum, and then begins to rise. Note that a business’s CCC is mi ’ • and its value is maximized at the same capital structure. Also note that general shapes of the curves apply once we consider the effects of fi ** • distress costs, regardless of whether we are using the MM with comrJ^ taxes model or the Miller model.
The fact that the same capital structure both minimizes the cost capital and maximizes value should be no surprise. The value of any business
EXHIBIT 10.5 Summary of
the Trade-Off Models
Effects of Leverage on Capital Costs
Cost of Capital
Effect of Leverage on Firm Value
Value of Firm, V
Chapter 10: Capital Structure 445
is nothing more than the present value of its expected after-tax operating income stream. What discount rate is used to find the present value? The answer is the CCC. Therefore, by minimizing its CCC, a business is auto- matically creating the greatest value.
Unfortunately, it is extremely difficult for financial managers to quan- tify the costs and benefits of debt financing to their firms, so it is virtually impossible to pinpoint the capital structure that truly maximizes a business’s value. Most experts believe that such a structure exists for every taxable busi- ness but that it changes substantially over time as the nature of the business and the capital markets changes. Most experts also believe that, as shown in the lower graph of Exhibit 10.5, the relationship between firm value and leverage is relatively flat; thus, relatively large deviations from the optimal structure can occur without materially affecting a business’s value.
Now, consider the asymmetric information model. Because of asym- metric information, investors know less about a firm’s prospects than its managers do. Furthermore, managers try to maximize value for current stock- holders, not new ones, so if the firm has excellent prospects, management will not want to issue new shares; however, if things look bleak, a new stock offering may be sold. Therefore, investors take a stock offering to be a signal of bad news, so stock prices tend to decline when new issues are announced. As a result, new equity financing can be expensive, and this factor must be incorporated into the capital structure decision. Its effect is to motivate firms to maintain a reserve borrowing capacity, which permits future investment opportunities to be financed by debt when internal funds are insufficient.
By combining the two theories, we obtain this possible explanation for the capital structure decisions of taxable firms:
• Debt financing provides benefits because of the tax deductibility of interest. Hence, firms should have some debt in their capital structures.
• However, financial distress costs place limits on debt usage—beyond some point, these costs offset the tax advantage of debt.
• Finally, because of asymmetric information, businesses maintain a reserve borrowing capacity to take advantage of good investment opportunities and, at the same time, avoid having to issue stock at distressed prices.
1. Do the capital structure models provide managers with quantifiable guidance regarding optimal capital structures?
2. Summarize the information that capital structure models provide to decision makers.
SELF-TEST QUESTIONS
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Application of Capital Structure Theory to Not-for-Profit Firms
So far, the discussion of capital structure theory has focused on investor owned businesses. Do the models presented in this chapter apply to not for-profit firms? No rigorous research has been conducted into the optimal capital structures of not-for-profit firms, but some loose analogies can be drawn. Although not-for-profit businesses do not receive a direct tax subsidy when debt financing is used, they do have access to the tax-exempt debt market, which provides an indirect tax subsidy. (If not-for-profits had to issue taxable debt, their costs of debt would be higher.) Thus, not-for-profit firms receive about the same tax advantages from the use of debt financing as do investor-owned firms.
What about the costs associated with equity (fund) financing? As discussed in Chapter 9, from a pure opportunity cost perspective, a not-for- profit firm’s fund capital has a cost that is roughly equivalent to the cost of equity of a similar investor-owned firm. Thus, we would expect the opportu- nity cost of fund capital to rise as more and more debt financing is used, just as for an investor-owned firm. After all, the use of debt financing increases the risk to the stakeholders of the organization. Furthermore, not-for-profit firms are subject to the same types of financial distress costs that are borne by investor-owned firms, so these costs are equally applicable. Even if the cost of equity is measured by the return required to support growth or maintain creditworthiness, increased risk means that a higher required rate of return is appropriate; hence, higher risk leads to a higher cost of fund capital.
Thus, we would expect the trade-off models to be roughly applicable to not-for-profit businesses and for such firms to have optimal capital struc- tures defined, at least in theory, as a trade-off between the costs and benefits of debt financing. Note, however, that the asymmetric information model is not applicable to not-for-profit firms because such firms do not sell common stock.
Although the trade-off models may be generally applicable to not-for- profit businesses, a problem arises in practice because for-profit firms have more or less unlimited access to equity capital. Thus, if they have more capital investment opportunities than they can finance with retained earnings and debt financing, investor-owned firms can always raise the needed funds by a new stock issue. (According to the asymmetric information theory, managers may not want to issue new stock, but the opportunity still exists.) Addition- ally, it is easy for investor-owned firms to alter their capital structures. If they are financially underleveraged—using too little debt—they can simply issue more debt and use the proceeds to repurchase stock. On the other hand,
Chapter 10: Capital Structure
•f they are financially overleveraged—using too much debt—they can issue Jditional shares and use the proceeds to refund debt.
Not-for-profit businesses do not have access to the equity markets; then- sole source of “equity” capital is through governmental grants, private contri- butions, and excess revenues (retained earnings). Thus, managers of not-for- profit organizations do not have the same degree of flexibility in either capital investment or capital structure decisions as do their proprietary counterparts.
The reduced access to equity capital means that it is often neces- sary for not-for-profit firms to (1) delay new projects, even profitable ones, because of funding insufficiencies and (2) use more than the theoretically optimal amount of debt because that is the only way that needed services can be financed. Although these actions may be required in certain situations, not-for-profit managers must recognize that such strategies increase costs. Project delays mean that needed services are not being provided on a timely basis. Using more debt than optimal pushes the firm beyond the point of the greatest net benefit of debt financing and hence drives capital costs up. If a not-for-profit firm is forced into a situation where it is using more than the optimal amount of debt financing, its managers should plan to reduce the firm’s level of debt as soon as the situation permits.
The ability of a not-for-profit business to garner governmental grants, attract private contributions, and generate excess revenues plays an important role in establishing its competitive position. A firm that has an adequate amount of fund capital can operate at its optimal capital structure and thus minimize capital costs. If insufficient fund capital is available, too much finan- cial leverage is then used and the result is higher capital costs. Consider two not-for-profit hospitals that are similar in all respects, except that one has more fund capital and can operate at its optimal structure while the other has insufficient fund capital and thus must use more debt financing than optimal. The hospital with insufficient fund capital must operate at an inefficient capi- tal structure. The former has a significant competitive advantage because it can offer either more services at the same cost by using additional (subopti- mal) debt financing or matching services at lower costs. Thus, sufficient fund capital provides the flexibility to offer all of the necessary services and still operate at the lowest capital cost structure. Just like firms that have low oper- ating cost structures, firms that are at their optimal capital structures—and hence have a low capital cost structure—have an advantage over their com- petitors that have higher capital cost structures.
1. Do the capital structure models apply to not-for-profit firms? 2. Why is capital structure important to not-for-profit firms?
SELF-TEST QUESTIONS
448 Understanding Healthcare Finance Management
Making the Capital Structure Decision
Although the trade-off and asymmetric information theories of capital struc ture provide many insights into the capital structure decision, theories alon cannot provide managers with a numerical answer. Thus, managers must apply judgment along with quantitative analysis.
Quantitative Analysis Businesses typically have a financial planning model that forecasts their
financial statements five years into the future. This model creates pro forma income statements and balance sheets on the basis of a large number of inputs, including financing decisions. By varying the future debt-equity mix managers can get a feel for the impact of capital structure on future financial performance; hence, this model can provide information that is valuable to the capital structure decision.
Qualitative Analysis The judgmental analysis involves several different factors, and in one situation
a particular factor might have great importance, while the same factor might be relatively unimportant in another situation. This section discusses some of the more important judgmental issues that should be taken into account.
Long-Run Viability Managers of businesses that provide vital healthcare services have a respon-
sibility to the community to provide those services for generations. Thus, they must refrain from using financial leverage to the point where the firm’s long-run viability is endangered.
Managerial Conservatism Well-diversified investors have eliminated most, if not all, of the diversifiable
risk from their portfolios. Therefore, the typical investor can tolerate some chance of financial distress because a loss on one stock will probably be offset by random gains on other stocks in the investor’s portfolio. However, man- agers of investor-owned firms often view financial distress with more concern because they typically are not well diversified in their careers, so the present value of their expected earnings can be seriously affected by the onset of financial distress. For this reason, managers might be more “conservative” in their use of leverage than the average stockholder would desire. If so, they would set somewhat lower target capital structures than those that maximize firm value.
For not-for-profit firms, one can argue that managerial conservatism is appropriate. Not-for-profit firms have no shareholders, and many of the
stakeholders are typically not well diversified in their relationships with the firm. Thus, these stakeholders have much more to lose if the firm fails than jo well-diversified shareholders of investor-owned firms.
Lender and Rating Agency Attitudes Regardless of a manager’s own analysis of the proper leverage for her firm, there is no question that lenders’ and rating agencies’ attitudes are frequently important determinants of financial structures. In the majority of cases, cor- porate managers discuss the firm’s financial structure with lenders and rating agencies and give much weight to their advice. Also, if a particular firm’s management is so confident of the future that it seeks to use leverage beyond the norms for its industry, its lenders may be unwilling to accept such debt increases, or they may do so only at a high price.
Rating agencies publish data that give managers the rough relation- ship between the use of debt financing and debt rating. For example, Exhibit 10.6 lists the relationship between financial leverage and debt rating for not- for-profit hospitals as reported by Standard & Poor’s. In general, the greater the use of debt, the lower the debt rating. Furthermore, managers typically want to maintain some target debt rating—say, single-A. If a hospital wants to target an A rating, according to the data in Exhibit 10.6 it should set an optimal capital structure of about 35 percent. Note, however, that factors other than financial leverage affect debt ratings, so the ratios provided by the rating agencies should be considered only rough guidance.
Reserve Borrowing Capacity Under the asymmetric information model, businesses should maintain a reserve borrowing capacity that preserves the ability to issue debt at favor- able terms if unanticipated needs arise. For example, suppose Merck had
Debt Rating Long-Term Debt/Capital Ratio AA+ 24.3% AA- 26.0 A+ 26.8 A 29.8 A- 36.4 BBB+ 37-0 BBB 36-5 BBB- 45-8 Speculative 47-9
Notes: i. Data are updated annually. 2. Capital is defined as long-term debt plus equity. Source: Standard & Poor’s (2012).
EXHIBIT 10.6
Relationship Between Financial Leverage and Debt Rating for Not-for-Profit Hospitals
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just successfully completed a research and development program on a new drug and its internal projections forecast much higher earnings in the future However, the new earnings are not yet anticipated by investors and hence are not reflected in the price of its stock. Merck’s managers would not want to issue stock; they would prefer to finance with debt until the higher earnings materialize and are reflected in the stock price, at which time the firm can sell an issue of common stock, retire the debt, and return to its target capi- tal structure. To maintain a reserve borrowing capacity, firms generally use less debt under “normal” conditions and hence present a stronger financial picture than they otherwise would. The use of less debt is not suboptimal from a long-run standpoint, although it might appear so if viewed strictly on a short-run basis.
Industry Averages Presumably, managers act rationally, so the capital structures of other firms in the industry, particularly the industry leaders, should provide insights into the optimal structure. In general, there is no reason to believe that the man- agers of one firm are better than the managers of any other firm. Thus, if one firm has a capital structure that is significantly different from other firms in its industry, the managers of that firm should identify the unique circumstances that contribute to the anomaly. If unique circumstances cannot be identified, it is doubtful that the firm has identified the correct target structure.
Control of Investor-Owned Corporations The effect that a firm’s choice of securities has on a management’s position of control may also influence its capital structure decision. If a firm’s man- agement barely has majority control—just over 50 percent of the stock—but is not in a position to buy any more stock, debt may be the choice for new financing. On the other hand, a management group that is not concerned about voting control may decide to use equity rather than debt if the firm’s financial situation is so weak that the use of debt might subject the firm to serious risk of default.
Asset Structure Firms whose assets are suitable as security for loans tend to use debt rather
heavily because the use of collateral provides access to lower-cost debt financing. Thus, hospitals tend to be highly leveraged, but firms involved in technological research employ relatively little debt. Also, if the firm’s assets carry high business risk, it will be less able to use financial leverage than a firm with low business risk will be. Accordingly, factors such as sales stability' and operating leverage, which influence business risk, also influence firms optimal capital structure. Thus, the greater the amount of “hard” assets and the lower the business risk, the greater the amount of debt financing used.
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Chapter 10: Capital Structure 451
Growth Rate Other factors being the same, faster-growing firms must rely more heavily on external capital—slow growth can be financed with retained earnings, but rapid growth generally requires the use of external funds. As postulated in the information asymmetry theory, businesses first use debt financing to meet external funding needs. Furthermore, the flotation costs involved in selling common stock exceed those incurred when selling debt. Thus, rapidly grow- ing firms tend to use more debt than do slower-growth firms.
Profitability Highly profitable firms do not need to use much debt financing because their high rates of return enable them to rely primarily on retained earnings. This behavior is consistent with the asymmetric information theory.
Taxes Interest is a deductible expense, while dividends are not deductible, so the higher a firm’s corporate tax rate, the greater the advantage of using corpo- rate debt.
Clearly, some of the considerations that go into the capital structure decision are quantitative and some are qualitative. Thus, in practice, the deci- sion requires a great deal of judgment. As mentioned earlier, businesses often use forecasting models to assess the impact of alternative capital structures on financial health, but the final decision always involves some judgment.
1. Is the capital structure decision mostly objective or subjective? 2. What are some of the factors that managers must consider when
setting a business’s optimal capital structure?
SELF-TEST QUESTIONS
Capital Structure Decisions for Small Investor-Owned Businesses
Capital structure theory, and its prescriptions for business behavior, is based on large corporations, in which owners and managers are separate groups and the securities issued are publicly traded. Thus, like its application to not-for- profit businesses, the application of capital structure theory to small investor- owned businesses raises questions more than provides answers.
In small businesses—say, a medical practice of one or a few physicians— die situation changes dramatically. Now, it is common to distribute returns to the owner/managers through salary bonuses as opposed to dividends. What makes this situation different? The key to the value of debt financing is that interest on debt financing is tax deductible to a business, while dividends on
452 Understanding Healthcare Finance Management
equity financing are not. In other words, interest is paid from pretax incons while dividends are paid from after-tax income. This asymmetric tax deduct’ ibility of interest creates the value inherent in the use of debt. As proved by MM, if there were no differential tax effects (the zero-tax case), the increase in riskiness to owners would exactly offset the benefits associated with a cost of debt that is lower than the cost of equity. The tax impact makes the effec tive cost of debt lower than that appropriate for the risk that it brings to the business, and this “externality” drives the value of debt financing.
When dividends to equityholders are paid in the form of bonuses they too are tax deductible to the business. Thus, we are in a situation in which there are tax advantages inherent in both debt and equity financing Debt financing still leverages up owners’ return, but the increase in risk that debt financing brings to owners either partially or fully offsets the increase in ROE. Thus, there is no clear value-increasing benefit to debt financing.
Should such small businesses still use debt financing? The answer is probably yes because owner/managers often cannot provide the amount of equity capital needed by the business. If owners do not have the capital needed by the business, and control considerations preclude bringing in out- side equity, debt financing is the only choice. Additionally, the use of debt financing means that less of the owners’ wealth is tied up in the business, so owners are better diversified in their personal investments.
Interestingly, the debt used by small businesses can be obtained either by the business or by the owners as personal debt, which would then be contributed to the business as equity. This situation amounts to the “homemade” leverage argument made by MM in their proofs. In general, if the business can borrow at a lower interest rate than the individual owners can, business debt makes sense, and vice versa. However, the issue becomes cloudy because, under many forms of organization, personal debt has differ- ent liability characteristics than business debt has. Adding to the complexity, the owners of small businesses typically have to sign personal guarantees on business debt, which further blurs the line between business and personal debt.
The bottom line here is that each small business situation is unique, and no guidance for capital structure decision making is applicable to all small business situations.
SELF-TEST QUESTION 1. Do the general prescriptions for capital structure decisions apply
to small businesses? Explain your answer.
Chapter 10: Capital Structure 453
Chapter Key Concepts This chapter presents a variety of topics related to capital structure deci- sions. Here are its key concepts:
• The use of debt financing increases the rate of return to owners, but it also increases their risk.
• Business risk is the inherent riskiness in a firm’s operations if it uses no debt financing. Financial risk is the additional risk that is concentrated on the business’s owners when debt financing is used.
• In 1958, Franco Modigliani and Merton Miller (MM) startled the academic community by proving, under a restrictive set of assumptions including zero taxes, that capital structure is irrelevant because a business’s value is not affected by its financing mix.
• MM later added corporate taxes to their model, leading to the conclusion that capital structure does matter and that businesses should use almost 100 percent debt financing to maximize value.
• The MM model with corporate taxes illustrates that the benefits of debt financing stem solely from the tax deductibility of interest payments.
• Much later, Miller extended the model to include personal taxes. The introduction of personal taxes reduces, but does not eliminate, the benefits of debt financing. Thus, the Miller model also prescribes 100 percent debt financing.
• The addition of financial distress costs to either die MM corporate tax model or the Miller model results in a trade-off model. Here, the marginal costs and benefits of debt financing are balanced against one another, and the result is an optimal capital structure that falls somewhere between 0 percent and 100 percent debt.
• Not-for-profit firms face a set of benefits and costs associated with debt financing similar to those faced by investor-owned firms, so the trade-off model is at least partially applicable to them. However, the inability to sell equity may keep a not-for- profit firm’s capital structure above the optimal point, at least temporarily. • The asymmetric information model, which is based on the
assumption that managers have better information than investors do, postulates that there is a preferred order to financing: retained
(continued)
454 Understanding Healthcare Finance Management
(continued from previous page)
earnings (and depreciation); then debt; and, as a last resort, new common stock.
• The asymmetric information model prescribes that businesses maintain a reserve borrowing capacity so that they can always issue debt on reasonable terms rather than be forced into a new equity issue at the wrong time.
• Unfortunately, capital structure theory does not provide neat, clean answers to the optimal capital structure question. Thus, many factors must be considered when actually choosing a firm’s target capital structure, and the final decision will be based on both analysis and judgment.
• In very small investor-owned businesses, such as a solo or small group medical practice, the situation is complicated by the fact that the owners and managers are the same people.
This chapter concludes our discussion of the cost of capital and capital structure. In chapters 11 and 12, we discuss capital budgeting decisions.
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
• A chapter model that shows how to perform many of the calculations described in the chapter
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and tests your
ability to perform the calculations in preparation for a case
These resources can be accessed on the book’s companion website at ache.org/books/UHFM7.
Selected Case
One case in Cases in Healthcare Finance, 5th edition, is applicable to this chapter:
• Case 19: RN Temp, Inc., which focuses on the choice between debt and equity financing for a for-profit business.
Selected Bibliography
Gordon, D. C. 2010. “Squeezing the Funding You Need from Today’s Capital Sources.” Health cure Financial Management 64 (4): 46-55.
Jarvis, W. 2012. “Organizational Debt Levels: Harbinger of Change?” Healthcare Financial Management 66 (1): 122-24.
Jarvis, W. 2013. “Rethinking Asset Allocation: The Case for Portfolio Diversifica- tion.” Healthcare Financial Management 67 (5): 140M2.
Means, G. A., and M. L. Olarte. 2013. “Today’s Trends in Capital Financing.” Healthcare Financial Management 67 (5): 60-66.
Sandrick, K. M. 2008. “Navigating Today’s Opportunities for Capital.” Healthcare Financial Management 62 (12): 78-83.
Sussman, J. H., M. E. Grubbe, and D. Samaris. 2009. “Ensuring Affordability of Your Hospital’s Strategies.” Healthcare Financial Management 63 (5): 42-48, 50.
Selected Websites
• Ohio State University maintains a website with video clips by various finance professionals briefly discussing topics of relevance to this course. Unfortunately, the clips do not include healthcare executives. To access the clips, go to http://fisher.osu.edu/departments/finance, click Resources and then Video Series. This will lead you to the available videos. For this chapter, try the clip by Dr. Stuart Myers titled “Theory of Corporate Finance in the 1950’s and 1960’s.”
• If you are interested in learning more about the consequences of Miller and Modigliani’s work as it pertains to stock repurchases, you may find Dr. Robert Shiller’s lecture, available through Open Yale Courses, to be of interest. That video can be accessed at http://oyc.yale.edu/ economics/econ-252-08/lecture-ll#transcript.
• Finally, you may take the opportunity to explore the work of Merton H. Miller by reading his Nobel Peace Prize lecture, which can be found at www.nobelprize.org/nobel_prizes/economic-sciences/ laureates/1990/miller-bio.html. Click on Prize Lecture on the left side.
Notes
1- The use of preferred stock has roughly the same effect on a business’s risk and return, and hence capital structure decision, as does debt
456 Understanding Healthcare Finance Management
financing. However, most businesses in the health services industry do not use preferred stock.
2. Per procedure leases are discussed in Chapter 8. 3. See the following MM articles: “The Cost of Capital, Corporation
Finance and the Theory of Investment,” American Economic Review (June 1958): 261-97; “The Cost of Capital, Corporation Finance and the Theory of Investment: Reply,” American Economic Review (September 1958): 655-69; “Taxes and the Cost of Capital: A Correction,” American Economic Review (June 1963): 433-43; and “Reply,” American Economic Review (June 1965): 524-27. In a 1979 survey of Financial Management Association members, the original MM article was judged to have had the greatest impact on the field of finance of any work ever published. See Cooley, P. L., and J. L. Heck. 1981. “Significant Contributions to Finance Literature.” Financial Management (Tenth Anniversary Issue): 23-33.
4. MM actually developed three propositions, but the third one is not material to our discussion.
5. Arbitrage is the simultaneous buying and selling of essentially identical assets at different prices. The buying increases the price of the undervalued asset, and the selling decreases the price of the overvalued asset. Arbitrage operations will continue until prices have been adjusted to the point where the arbitrager can no longer earn a profit. At this point, the prices are in equilibrium.
6. For an illustration of MM’s arbitrage proof, see Brigham, E. F., and M. C. Ehrhardt. 2013. “Chapter 21.” In Financial Management: Theory and Practice, 14th ed. Mason, OH: South-Western Cengage Learning.
7. The annual interest expense associated with D dollars of debt financing is R(Rd) x D, and the resulting tax savings is T x R(Rd) x D. Because MM assumed that all cash flows are perpetuities, the present value of the tax savings stream is [T x R(Rd) x D]/R(Rd) = T x D.
8. See Miller, M. H. 1977. “Debt and Taxes.” Journal of Finance (May): 261-75. The paper was first presented as the presidential address at the 1976 meeting of the American Finance Association.
9. Over the past 20 years, the tax rate on equity income has changed several times, resulting in a dividend tax rate that has been less than the tax rate on debt (interest) income during some periods and equal to the rate on debt income during other periods. However, the fact that capital gains taxes are deferred into the future while taxes on debt income must be paid when the interest is received makes the effective
tax rate on equity income lower than the effective rate on debt income, even when the statutory rates are the same.
10. For examples of empirical research in this area, see Taggart, R. 1977. “A Model of Corporate Financing Decisions.” Journal of Finance (December): 1467-84, and Marsh, P. 1982. “The Choice Between Equity and Debt: An Empirical Study.” Journal of Finance (March): 121-44.
11. See Donaldson, G. 1961. Corporate Debt Capacity: A Study of Corporate Debt Policy and the Determination of Corporate Debt Capacity. Cambridge, MA: Harvard Graduate School of Business Administration.
12. See Myers, S. C. 1984. “The Capital Structure Puzzle.” Journal of Finance (July): 575-92. It is interesting to note that, like the Miller model, Myers’s paper was presented as a presidential address to the American Finance Association.
13. Many studies support the contention that the announcement of a new stock issue prompts a decrease in stock price. For example, one study found that stock prices decline about 3 percent following the announcement of a new stock issue. See Asquith, P., and D. W. Mullins, Jr. 1986. “Equity Issues and Offering Dilution.” Journal of Financial Economics (June): 61-89.
458 Understanding Healthcare Finance Management
Integrative Application
The Problem
STU Rehabilitation currently has no debt. An in-house research group has just been assigned the job of determining whether the firm should change its capi- tal structure. Because of the importance of the decision, management has also hired the investment banking firm of Morgan & Company to conduct a parallel analysis of the situation. Both analyses will use the MM with taxes framework (incorporating the probability of financial distress). Mr. Harris, the in-house analyst who has a good knowledge of the firm and is confident of his ability to predict the firm’s probability of financial distress at various levels of debt, has decided to estimate the optimal capital structure as the one that maximizes the value of the levered firm. Ms. Broske, the Stanley Morgan consultant who has a good knowledge of capital market conditions and is confident of her ability to predict the firm’s debt and equity costs at various levels of debt, has decided to estimate the optimal capital structure as the one that minimizes the firm’s corpo- rate cost of capital.
The following data are relevant to both analyses:
EBIT per year, in perpetuity: $4 million
Tax rate: 40%
Required rate of return on equity (unlevered): 12%
PV of financial distress costs: $8 million
The cost-of-capital schedule predicted by Ms. Broske and the probabilities of financial distress predicted by Mr. Harris are as follows (where FD is financial distress):
Debt Level (in millions of dollars)
$0 $2 $4 $6 $8 $10 $12 $14
ROV 8.0% 8.3% 9.0% 10.0% 11.0% 13.0% 16.0% ROV 12.00% 12.25% 12.75% 13.00% 13.15% 13.40% 14.65% 17.00% Prob (FD) 0% 0% 5% 7% 10% 17% 47% 90%
The problem is to determine the level of debt that Mr. Harris would recom- mend and the level of debt that Ms. Broske would recommend.
Chapter 10: Capital Structure 459
The Analysis
/Vlr. Harris’s analysis is summarized below:
Debt Level (in millions of dollars)
$0 $2 $4 $6 $8 $10 $12 $14
Vu $20.00 $20.00 $20.00 $20.00 $20.00 $20.00 $20.00 $20.00 TxD $ 0.00 $ 0.80 $ 1.60 $ 2.40 $ 3-20 $ 4.00 $ 4.8O $ 5.60
PV of FD
$ 0.00 $ 0.00 $ 0.40 $ 0.56 $ 0.80 $ 1.36 $ 3.76 $ 7.20
vL $20.00 $20.80 $21.20 $21.84 $22.40 $22.64 $21.04 $18.40
The table shows that the optimal capital structure occurs at a debt level of $10 million: At this amount of debt, the value of the levered firm (VL) is maxi- mized at $22.64 million. This value is obtained as follows:
.... EBIT x (1 - T) $4 million x 0.6 ± .... VU = -- --- -- ---- --— = —------------------= $20.00 million
R(RReU) 0.12
T x D = 0.4 x $10 million = $4.00 million
PV of FD = 17% x $8 million = $1.36 million
VL = $20.00 million + $4.00 million - $1.36 million = $22.64 million
Ms. Broske’s analysis is summarized as follows:
$0 $2 $4 $6 $8 $10 $12 $14
E = VL-D $20.00 $18.80 $17.20 $15.84 $14.40 $12.64 $9-04 $4.40 wd = D / vb 0% 10% 19% 27% 36% 44% 57% 76% W = E 1 VL 100% 90% 81% 73% 64% 56% 43% 24%
CCC 12.0% 11.5% 11.3% 10.9% 10.6% 10.4% 10.7% 11.4%
The table shows that the optimal capital structure occurs at a debt level of $10 million. At this amount of debt, the CCC is minimized at 10.4 percent. This value is obtained as follows:
E = VL - D = $22.64 million - $10.00 million = $12.64 million
wd = D / VL = $10.00 million / $22.64 million = 44%
we = E / VL = $12.64 million / $22.64 million = 56%
CCC = [wd x R(Rd) x (1 - T)] + [we x R(ReL)]
= [44% x 11.0% x 0.6] + [56% x 13.4%] = 10.4%.
46O Understanding Healthcare Finance Management
The Decision
STU Rehabilitation decided to issue $10 million of debt. At this level of debt, the value of the firm is maximized and the CCC is minimized. ■
CHAPTER SUPPLEMENT
THE DEBT MATURITY DECISION 10 Supplement Learning Objective After studying this chapter supplement, readers should be able to
• explain how businesses choose debt maturities.
The Concept of Temporary and Permanent Assets
Thus far, we have focused on the primary capital structure decision, which is identifying the optimal mix of debt and equity financing. Once this deci- sion is made, a secondary decision arises: What is the optimal mix of debt maturities? In other words, what is the optimal debt maturity structure*. As with the optimal capital structure, the answer involves a trade-off between risk and return.
Most businesses experience seasonal and/or cyclical fluctuations in demand. Typically, businesses respond to such fluctuations by having a suf- ficient level of fixed assets on hand to meet peak demand needs but allowing current assets to fluctuate as necessary to match rising and falling demand conditions. Still, current assets never drop to zero, and this realization has led to the concept of permanent versus temporary assets.
For example, consider Sun Coast Clinics, a for-profit operator of four ambulatory care clinics in South Florida. Exhibit SI0.1 contains the busi- ness’s December 2013 and April 2014 balance sheets. Sun Coast’s optimal, or target, capital structure is 40^5 percent debt financing, and its current structure falls within this range. The question now is, What maturity struc- ture should Sun Coast use for its debt financing?
Note that the provision of ambulatory care services in this part of Florida is a seasonal business. The peak season for Sun Coast is December through April, when the population of the area soars because of tourism. Even more important to Sun Coast’s peak level of operations is the arrival of the “snow birds” (i.e., retirees who typically live in the north during the summer and fall months but move to residences in Florida for the winter).
In December of each year, Sun Coast has just finished its slow season and is preparing for its busy season. Thus, the firm’s accounts receivable are relatively low, but its cash and marketable securities and inventories are rela- tively high. By the end of April, Sun Coast has completed its busy season, so
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EXHIBIT S10.1 Sun Coast
Clinics, Inc.: End-of-Month
Balance Sheets (in thousands
of dollars)
December 2013 APril2oi4 Cash and marketable securities $ 30 $ 20 Accounts receivable 155 210 Inventories 15 10
Total current assets $200 $240 Net fixed assets 500 5oo
Total assets $700 $740
Accounts payable $ 30 $ 40 Accruals 15 2S Short-term debt 85 IO5
Total current liabilities $130 $170 Long-term debt 170 VO Common equity 400 400
Total liabilities and equity $700 $740
Note: These statements have been simplified for ease of illustration.
its accounts receivable are relatively high, but its cash and marketable securi- ties and inventories are relatively low in preparation for the slow summer sea- son. On the current liabilities side, Sun Coast’s accounts payable and accruals are relatively high at the end of April, just after the busy season. Sun Coast’s fluctuations in assets and liabilities result from seasonal factors. Similar fluctu- ations in current asset requirements, and hence in financing needs, can occur because of business cycles; typically, current asset requirements and financing needs contract during recessions and expand during prosperous times.
At this stage in its life cycle, Sun Coast’s total assets fluctuate between $700,000 and $740,000. The minimum amount of total assets required to sustain operations during seasonal, or cyclical, lows is defined as a firm’s per- manent assets. Thus, Sun Coast has $700,000 of permanent assets, which are composed of $500,000 of fixed assets and $200,000 of permanent current assets. By their nature, fixed assets are always considered permanent, so tem- porary assets arise solely from current assets. Sun Coast carries temporary cur- rent assets that fluctuate seasonally from zero to a maximum of $40,000. The manner in which the permanent and temporary current assets are financed defines the business’s debt maturity mix.
Alternative Debt Maturity Policies
There are three basic debt maturity policies: (1) maturity matching, (2) aggressive approach, and (3) conservative approach.
r Maturity Matching
Chapter 10 Supplement: The Debt Maturity Decision 463
Maturity matching is a moderate approach to the debt maturity decision. Businesses that take this approach match asset and liability maturities in the financial sense—that is, they finance permanent assets with permanent capital (i.e., equity and long-term debt) and finance temporary assets with temporary capital (i.e., short-term debt). For example, if Sun Coast were using this strategy, it would have $700,000 of permanent financing. It has $400,000 in equity, which suggests it has $300,000 in long-term debt. However, Sun Coast will take all the free financing it can get, so it will use the Accounts payable + Accruals = $30,000 + $15,000 = $45,000 in spon- taneous (free) current liabilities available during the slow season to replace long-term debt. Thus, maturity matching would call for $400,000 in equity, $255,000 in long-term debt, and $45,000 in free current liabilities for a total of $700,000 in financing. This is all the financing that would be on the books in December 2013. To get to April 2014, Sun Coast would use $20,000 of short-term debt. Although total assets increase by $40,000, the business gets the benefit of an additional $20,000 of free current liabilities, so only $20,000 of short-term debt is needed.
The maturity-matching strategy limits the risk that a business will be unable to pay off its maturing obligations. To see this point, suppose Sun Coast borrows on a one-year basis and uses the funds to build and equip a new clinic. Cash flows from the clinic (i.e., profits plus depreciation) are not sufficient to pay off the loan at the end of only one year, so the loan must be renewed at that time. If interest rates increase during the year, Sun Coast’s new debt will cost more. Even worse, if the lender refuses to renew the loan, Sun Coast will have problems. Had the clinic been financed with long-term financing, the required loan payments would have been better matched with cash flows from profits and depreciation and the problem of loan renewal would not have arisen.
At the limit, a business can attempt to match exactly the maturity structure of its assets and liabilities. Inventory expected to be sold in 30 days can be financed with a 30-day bank loan, a machine expected to last for 5 years can be financed by a 5-year loan, a 20-year building can be financed by a 20-year mortgage bond, and so forth. Three factors make this exact maturity-matching strategy unpractical and wrong: (1) The lives of assets are uncertain; (2) some common equity, or fund capital, must be used, and this capital has no maturity; and (3) to develop a sound current asset financing policy, it is necessary to consider whether an asset is permanent or temporary.
Aggressive Approach A business that takes the aggressive approach finances part of its permanent current assets with short-term debt. A look back at Exhibit SI0.1 shows that Sun Coast follows this strategy. Sun Coast has $500,000 in net fixed assets
C hapter 10 Supplem
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464 Understanding Healthcare Finance Management
and $570,000 of long-term capital, leaving only $70,000 of long-term tai to finance $200,000 in permanent current assets. Additionally, Sun CM has a minimum of $45,000 of free short-term liabilities. Thus, Sun CoJ must use $200,000 - $70,000 - $45,000 = $85,000 of short-term debt^ help finance its permanent level of current assets.
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There are an almost infinite number of degrees of aggressiveness Fo example, at the extreme, Sun Coast can replace the $170,000 of long-term debt with short-term debt and hence have only $400,000 of permanent capital—its equity. Such a policy would be a highly aggressive, extremely unconservative position, and Sun Coast would be subject to dangers from rising interest rates as well as to loan renewal problems. However, short-term debt is often cheaper than long-term debt, and some businesses are willing to take on additional financial risk for the chance of higher profits.
Conservative Approach In the conservative approach, the level of permanent financing exceeds the level of permanent assets. For Sun Coast, the conservative approach would call for, say, $400,000 in equity plus $300,000 in long-term debt for total permanent financing of $700,000. Then, $45,000 of marketable securities would be held at the end of December 2013, and $65,000 would be held at the end of April 2014. The conservative approach provides Sun Coast with a “safety” reserve of liquid assets that can be tapped at any time to cover unexpected operating losses or for other purposes.
Conclusions Regarding Debt Maturities
The proper framework for evaluating debt maturity policies requires the use of the concept of permanent and temporary assets. Thus, for financing pur- poses, assets are not classified by their accounting definitions of current and long term but rather as either permanent or temporary. In this framework, maturity matching calls for the permanent portion of cash, receivables, and inventories (i.e., permanent current assets) to be financed with permanent capital (i.e., long-term debt and equity). The key is that each dollar of cash, each individual receivable, and each dollar of inventory may well be short term in that these items will be quickly turned over or converted to cash. However, as each individual current asset item is converted, it will be replaced by a like item if it is permanent in nature; hence, such short-term assets are actually carried permanendy over the long term. The implication is that the accounting definition of current assets, although useful for many purposes, does not provide managers with correct guidance regarding the financing of such assets.
Chapter 10 Supplement: The Debt Maturity Decision
The choice among alternative financing policies involves a risk-return [ratle-offi The aggressive policy, with its high use of generally lower-cost short-term debt, has the highest expected return but the highest risk, while the conservative policy has the lowest expected return and lowest risk. The maturity-matching policy falls between the extremes. Unfortunately, there is no underlying finance theory that managers can use to pick the “correct” debt maturity policy. Often, firms that have low business risk elect to take on higher-than-average financial risk. Thus, such firms tend to have more debt ,n their target capital structures and are more likely to use an aggressive debt maturity policy. Conversely, firms with high business risk usually take a con- servative view regarding added financial risk, whether that risk arises from a high level of debt or an aggressive debt maturity policy.
1. Explain the difference between permanent and temporary assets. 2. What are the three strategies for choosing debt maturities? 3. How is the choice made?
SELF-TEST QUESTIONS
Supplement Key Concepts This chapter supplement presents some background information on the debt maturity' decision. Here are its key concepts:
• The second decision regarding capital structure is the selection of debt maturities.
• There are three general approaches to debt maturities: (1) maturity matching, (2) aggressive, and (3) conservative.
• The debt maturity choice is a classic risk-return trade-off.
PART
V CAPITAL ALLOCATION
In parts III and IV, we focus on capital acquisition (long-term financing),including capital structure decisions and cost-of-capital estimation—inother words, how businesses raise the funds used to buy needed land, buildings, and equipment and the cost of those funds. Now, we turn our attention to the capital allocation decision—or how those funds can be deployed (spent) in the most financially efficient manner. The overall process of choosing the projects to be undertaken by a business is called capital budgeting.
Our discussion of capital allocation spans two chapters. Perhaps the most critical part of capital budgeting involves cash flow estimation, because the financial attractiveness of proposed projects stems solely from the cash flows they are expected to produce. Chapter 11 covers the basic concepts of capital budgeting, including how to estimate a project’s cash flows and how to measure its expected financial impact.
In addition to cash flow estimation, an important consideration in capital budgeting is project risk. Chapter 12 explains how to assess the riski- ness of a project and incorporate that assessment into the capital budgeting decision process.
r
CHAPTER
CAPITAL BUDGETING 11 Learning Objectives After studying this chapter, readers will be able to
• explain how managers use project classifications and post-audits in the capital budgeting process;
• discuss the role of financial analysis in health services capital budgeting decisions;
• discuss the key elements of cash flow estimation, breakeven analysis, and profitability analysis; and
• conduct basic capital budgeting analyses.
Introduction
Chapters 9 and 10 described how healthcare managers estimate their busi- ness’s corporate cost of capital and make capital structure decisions. Now, we change our focus to fixed-asset acquisition decisions, which entail the acquisition of new facilities or equipment. Because such decisions require the use, or expenditure, of capital, they are called capital investment, or capital budgeting, decisions. The term capital budgeting is used because the listing of projects to be undertaken in some future planning period, along with their total dollar cost, is called the capital budget. Capital budgeting decisions are of fundamental importance to the success or failure of any business because a firm’s capital budgeting decisions, more than anything else, shape its future.
The discussion of capital budgeting is divided into two chapters. Chapter 11 provides an overview of the capital budgeting process, a discus- sion of the key elements of project cash flow estimation, and an explanation of the basic techniques used to assess a project’s breakeven characteristics and profitability. In Chapter 12, capital budgeting risk analysis and the optimal capital budget are considered.
Importance of Capital Budgeting Capital budgeting decisions are among the most critical decisions that health- care managers must make. First, and most important, the results of capital budgeting decisions generally affect the business for an extended period. If
469
a business invests too heavily in facilities and equipment (fixed assets) it have too much capacity and its costs will necessarily be too high. On the other hand, a business that invests too little in fixed assets may face two problems- (1) technological obsolescence and (2) inadequate capacity. A healthcare pro' vider without the latest technology will lose patients to its more up-to-date competitors and will deprive its patients of the best healthcare diagnostics and treatments available. A provider with inadequate capacity may lose a portion of its market share to competitors, which would then require it to increase its marketing costs or aggressively reduce prices to regain the lost share.
Effective capital budgeting procedures provide several benefits to busi- nesses. A business that forecasts its needs for capital assets well in advance can plan the purchases carefully and thus negotiate the highest-quality assets at the best prices. Additionally, asset expansion typically involves substantial expenditures, and because large amounts of funds are not usually on hand, they must be raised externally. Good capital budgeting practices enable a business to identify its financing needs and sources well in advance, which ensures the lowest possible capital procurement costs and availability of funds as they arc needed.
SELF-TEST QUESTIONS 1. Why are capital budgeting decisions so crucial to the success of a
business? 2. What are the benefits of effective capital budgeting procedures?
Project Classifications
Although benefits can be gained from the careful analysis of capital invest- ment proposals, such efforts can be costly. For certain types of projects, a relatively detailed analysis may be warranted; for others, cost-benefit stud- ies suggest that simpler procedures should be used. Accordingly, healthcare businesses generally classify projects into categories and then analyze those in each category differently. For example, Ridgeland Community Hospital, a not-for-profit hospital, uses the following classifications:
• Category 1: Mandatory replacement. This category consists of expenditures necessary to replace worn-out or damaged equipment necessary to the operations of the hospital. In general, these expenditures are mandatory, so they are usually made without going through an elaborate decision process.
• Category 2: Discretionary replacement. This category includes expenditures made to replace serviceable but obsolete equipment.
Chapter 11: Capital Budgeting 471
The purpose of these projects generally is to lower costs or to provide more clinically effective services. Because Category 2 projects are not mandatory, a more detailed analysis is generally required to support the expenditure than that needed for Category 1 projects.
• Category 3: Expansion of existing products, services, or markets. This category includes expenditures made to increase capacity or to expand within markets currently served. These decisions are more complex, so still more detailed analysis is required, and the final decision is made at a higher level in the organization.
• Category 4: Expansion into new products, services, or markets. This category consists of projects necessary to provide new products or services or to expand into geographic areas not currently served. Such projects involve strategic decisions that can change the fundamental nature of the hospital, and they normally require the expenditure of large sums of money over long periods. Invariably, a particularly detailed analysis is required, and the board of trustees generally makes the final decision as part of the hospital’s strategic planning process.
• Category 5: Safety/environmental projects. This category consists of expenditures necessary to comply with government orders, labor agreements, accreditation requirements, and so on. Unless the expenditures are large, Category 5 expenditures are treated like Category 1 expenditures.
• Category 6: Other. This category is a catchall for projects that do not fit neatly into any of the previous categories. The primary determinant of how Category 6 projects are evaluated is the amount of funds required. In general, relatively simple analysis and only a few supporting documents are required for replacement decisions and safety/environmental projects, especially those that are mandatory. A more detailed analysis is required for expansion and other projects.
Note that, within each category, projects are classified by size. Larger projects require increasingly detailed analysis and approval at a higher level in the hospital. For example, department heads can authorize spending up to $25,000 on discretionary replacement projects, while the full board of direc- tors must approve expansion projects that cost more than $5 million.
1. What is the primary advantage of classifying capital projects? 2. What are some typical classifications? 3. What role does project size (cost) play in the classifications?
SELF-TEST QUESTIONS
Understanding Healthcare Finance Management
The Role of Financial Analysis in Health Services Caoitai Budgeting
For investor-owned businesses, for which shareholder wealth maximization is an important goal, the role of financial analysis in investment decisions is clear. Projects that will contribute to shareholder wealth should be under- taken, while those that will not should be ignored. However, what about not-for-profit businesses that do not have shareholder wealth maximization as a goal? In such businesses, the appropriate goal is providing quality, cost- effective service to the communities served. (A strong argument can be made that investor-owned firms in the health services industry should also have this goal.) In this situation, capital budgeting decisions must consider many factors besides a project’s financial implications. For example, the needs of the medi- cal staff and the good of the community must be taken into account. In some instances, these noneconomic factors will outweigh financial considerations.
Nevertheless, good decision making, and hence the future viability of health services organizations, requires that the financial impact of capi- tal investments be fully recognized. If a business takes on a series of highly unprofitable projects that meet nonfinancial goals, and such projects are not offset by other profitable projects, the business’s financial condition will dete- riorate. If this situation persists over time, the business will eventually lose its financial viability and may even be forced into bankruptcy and closure.
Because bankrupt businesses obviously cannot meet a community’s needs, even managers of not-for-profit businesses must consider a project’s potential impact on the firm’s financial condition. Managers may make a con- scious decision to accept a project with a poor financial prognosis because of its nonfinancial virtues, but it is important that managers know the financial impact up front, rather than be surprised when the project drains the firm’s financial resources. Financial analysis provides managers with relevant informa- tion about a project’s financial impact and hence helps managers make better decisions, including decisions based primarily on nonfinancial considerations.
SELF-TEST QUESTIONS 1. What is the role of financial analysis in capital budgeting decision
making in for-profit firms? 2. Why is financial analysis of projects important in not-for-profit
businesses?
Overview of Capital Budgeting Financial Analysis
The financial analysis of capital investment proposals typically involves the following four steps:
Chapter 11: Capital Budgeting 473
r l. Estimate the project’s expected cash flows, which consist of
a. the capital outlay, or cost; b. the operating cash flows; and c. the terminal (ending) cash flow. (Cash flow estimation is discussed
in the next section.) 2. Assess the riskiness of the estimated cash flows. (Risk assessment is
discussed in Chapter 12.) 3. Given the riskiness of the project, estimate the project’s cost of capital
(opportunity cost, or discount, rate). As discussed in Chapter 9, a business’s corporate cost of capital reflects the aggregate risk of the business’s assets—that is, the riskiness inherent in the average project. If the project being evaluated does not have average risk, the corporate cost of capital must be adjusted.
4. Assess the financial impact of the project, including profitability. Several measures can be used for this purpose; we will discuss five in this chapter.
1. Describe the four steps in capital budgeting financial analysis. SELF-TEST QUESTION
Cash Flow Estimation
The most important—but also the most difficult—step in evaluating capital investment proposals is cash flow estimation: the investment outlays, the annual net operating flows expected when the project goes into operation, and the cash flows associated with project termination. Many variables are involved in cash flow forecasting, and many individuals and departments participate in the process. It is difficult to make accurate projections of the revenues and costs associated with a large, complex project, so forecast errors can be large. Thus, it is essential that risk analyses be performed on prospec- tive projects. One manager with a good sense of humor developed the fol- lowing five principles of capital-budgeting cash flow estimation:
1. It is difficult to forecast cash flows, especially those that occur in the future.
2. Those who live by the crystal ball soon learn how to eat ground glass. 3. The moment you forecast cash flows, you know that you are wrong;
you just don’t know by how much and in what direction. 4. If you are right, never let your bosses forget. 5. An expert is someone who has been right at least once.
Understanding Healthcare Finance Management 474
It is hard to overstate the difficulty and importance of correctly f casting a project’s cash flows. However, if the principles discussed in the ' sections are observed, errors that often arise in the process can be minimi/^' Also, because cash flow estimation is so difficult, Chapter 12 presents sev | techniques managers use to measure and account for cash flow uncertainty
Identifying the Relevant Cash Flows In the evaluation of a new capital investment, the relevant cash flows arc the project’s incremental cash flows, which are defined as the difference between the firm’s cash flows in each period if the project is undertaken and the firm’s cash flows if the project is not undertaken:
Incremental CFt = CFt(Rrm with proj(Xt) - CFt(Firm without projcct)
Here, the subscript t specifies a period—normally years—so CF0 is the cash flow during Year 0, which is generally assumed to be the beginning of the project; CF, is the cash flow during the Year 1; CF2 is the cash flow dur- ing Year 2; and so on. In practice, the early cash flows, particularly those in Year 0, are usually cash outflows—the costs associated with getting the proj- ect “up and running.” As the project begins to generate operating revenues, the cash flows normally turn positive.
Cash Flow Versus Accounting Income Accounting income statements prepared in accordance with generally accepted accounting principles are in some respects a mix of apples and oranges. For example, accountants deduct labor costs (which are cash out- flows) from revenues (which may not be entirely cash). (For healthcare providers, most of the collections are from third-party payers, and payment may not be received until several months after the service is provided.) At the same time, the income statement does not recognize capital outlays (which are cash flows), but it does deduct depreciation expense (which is not a cash flow). In capital investment decisions, it is critical that the decision be based on the actual dollars that flow into and out of the business because a busi- ness’s true profitability—and hence its ability to provide healthcare services— depends on its cash flows and not on income as reported in accordance with generally7 accepted accounting principles. Note, however, that accounting items can influence cash flows because items like depreciation can affect tax or reimbursement cash flows.
Cash Flow Timing Financial analysts must be careful to account for the timing of cash flows. Accounting income statements are for periods, such as years or quarters, so
Chapter 11: Capital Budgeting 475
they do not reflect exactly when revenues and expenses occur during the period. In theory, capital budgeting cash flows should be analyzed exactly as they occur. Of course, there must be a compromise between accuracy and simplicity- A time line with daily cash flows would, in theory, provide the rtiost accuracy, but daily cash flow estimates are difficult to perform, unwieldy to use, and probably no more accurate than annual cash flow estimates. Thus, in most cases, analysts assume all cash flows occur at year-end. However, for some projects, it may be useful to assume cash flows occur every six months or even to forecast quarterly or monthly cash flows.
Project Life One of the first decisions that must be made in forecasting a project’s cash flows is the life of the project: Do we need to forecast cash flows for 20 years, or is a period of five years sufficient? Many projects, such as a new hospital wing or an ambulatory care clinic, potentially have very long lives—perhaps as long as 50 years. In theory, a cash flow forecast should extend for the full life of a project, yet most managers would have little confidence in any cash flow forecasts beyond the near term. Thus, most organizations set an arbi- trary limit on the project life assumed in capital budgeting analyses—often five or ten years. If the forecasted life is less than the arbitrary limit, the fore- casted life is used to develop the cash flows. If the forecasted life exceeds the limit, project life is truncated and the operating cash flows beyond the limit are ignored in the analysis.
Although cash flow truncation is a practical solution to one problem, it creates another problem—the value inherent in the cash flows beyond the truncation point is lost to the project. This problem can be addressed either objectively or subjectively. The standard procedure at some organizations is to estimate the project’s terminal value, which is a proxy for the value of the cash flows beyond the truncation point. Often, the terminal value is estimated as the liquidation value of the project at that point in time. If the terminal value is too difficult to estimate, the fact that some portion of the project’s cash flow stream is being ignored should, at a minimum, be subjec- tively recognized by decision makers. The saving grace is that cash flows well into the future typically contribute a relatively small amount to a project’s profitability. For example, a $100,000 terminal value projected ten years into the future contributes only about $38,500 to the project’s initial value when the cost of capital (discount rate) is 10 percent.
Sunk Costs A sunk cost refers to an outlay that has already occurred or has been irrevo- cably committed, so it is an outlay that is unaffected by the current decision to accept or reject the project. For example, suppose that in 2014 Ridgeland
Community Hospital is evaluating the purchase of a lithotripter system Fo help with the decision, the hospin' hired and paid $10,000 to a consultant in 2013 to conduct a marketing study. Is this 2013 cash flow relevant to th 2014 capital investment decision? The answer is no. The $10,000 is a sunk cost; Ridgeland cannot recover it whether or not the lithotripter is purchased Costs, such as sunk costs, as well as other cash flows that are not relevant to an analysis are called nonincremental cash flows. Sometimes a project appears to be unprofitable when all of the associated costs, including sunk costs are considered. However, on an incremental basis, the project may be profitable and should be undertaken. Thus, the correct treatment of sunk costs may be critical to the decision.
Assume for a moment that Ridgeland goes ahead with the lithotripter project. Then, in 2015, when conducting a periodic analysis of the historical profitability of the project, the $10,000 cost of the consultant’s report might be included because it was part of the total cash flows attributable to the project. Still, when making the 2014 decision regarding whether to go ahead with the project, the $10,000 is nonincremental and hence not relevant to the decision.
Opportunity Costs All relevant opportunity costs must be included in a capital investment analysis. Note that one opportunity cost involves the use of the capital. When Ridge- land uses its capital to invest in a lithotripter system, it cannot use the same capital to invest in, say, a new surgical suite. The opportunity cost associated with capital use is accounted for in the project’s cost of capital, which is used to discount the project’s expected cash flows and represents the return that the business can earn by investing in alternative investments of similar risk. Thus, the opportunity cost associated with capital is automatically considered in a project analysis by the mathematics of the discounting process.
There are other types of opportunity costs, and all such costs should be built into a project’s cash flows. For example, assume that Ridgeland’s lithotripter would be installed in a freestanding facility and that the hospital currently owns the land on which the facility would be constructed. The hos- pital purchased the land ten years ago at a cost of $50,000, but the current market value of the property is $130,000, net of taxes (if applicable) and fees. When evaluating the lithotripter, should we disregard the value of the land because no cash outlay is necessary? The answer is “no,” because there is an opportunity cost inherent in the use of the property. Using the property for the lithotripter facility deprives Ridgeland of its use for anything else. The hospital might use the property for a walk-in clinic, an ambulatory surgery center, or a parking garage rather than sell it, but the best measure of the property’s value to Ridgeland—and hence the opportunity cost inherent in
Chapter 11: Capital Budgeting
its use—is the cash flow that can be realized by selling it. By considering the property’s current market value, the hospital is letting market forces assign a value to the land’s best alternative use. Thus, the lithotripter project should have a $130,000 opportunity cost charged against it. Note that the opportu- nity cost is the property’s $130,000 net market value, irrespective of whether the property was acquired for $50,000 or $200,000.
Effect on the Business's Other Projects Capital budgeting analyses must consider the effect of the project under consideration on the business’s other projects. When the effect is negative, it is often called cannibalization because the project is expected to “eat away” at other revenues. For example, assume that some of the patients who are expected to use Ridgeland’s new lithotripter would have been treated surgi- cally at the hospital, so these surgical revenues will be lost if the lithotripter facility goes into operation. Thus, the incremental revenues to Ridgeland are the revenues attributable to the lithotripter less the revenues lost from forgone surgery services. Of course, the costs saved by losing these surgery patients would be a benefit to the lithotripter project and hence should also be considered in the analysis. Note, however, that if the surgical patients would be lost to competitors that are buying lithotripters, the loss of these patients does not affect the lithotripter project analysis because these losses would occur whether or not the lithotripter project is accepted.
Thus far, we have focused on the negative impact of a new project on other services. The impact can be positive. For example, new patients who use the lithotripter may at the same time use other services provided by the hospital, such as imaging services. In this situation, the incremental cash flows generated by the lithotripter patients’ utilization of other services should be credited to the lithotripter project. In theory, if the lithotripter brings new patients to the hospital who otherwise would go elsewhere, all of the profits from these patients should be attributed to the lithotripter project. Of course, such cash flows would be difficult to estimate. If possible, both positive and negative effects on other projects should be quantified; at a minimum, they should be noted so that the final decision maker is aware of their existence.
Shipping and Installation Costs When a firm acquires new equipment, it often incurs substantial costs for shipping and installation. These charges are added to the invoice price of the equipment to determine the overall cost of the project. Also, the full cost of the equipment, including shipping and installation charges, is used as the basis for calculating depreciation expense. Thus, if Ridgeland purchases inten- sive care monitoring equipment that costs $200,000 but another $50,000 is required for shipping and installation, the full cost of the equipment would
Understanding Healthcare Finance Management
be $250,000, and this amount would be the starting point (cost basis) fi both tax (when applicable) and all depreciation calculations.
Changes in Net Working Capital Normally, expansion projects require additional inventories, and added patient services also lead to additional accounts receivable. The increase in these current asset accounts must be financed, just as an increase in fixed assets must be financed. (To keep the balance sheet balanced, we must off- set any increases on the left side with increases on the right side.) However accounts payable and accruals will probably also increase as a result of the expansion, and these current liability additions will reduce the cash needed to finance the increase in inventories and receivables. The difference between the increase in current assets and the increase in current liabilities that directly result from a new project is called a change in net working capital.
If the change in net working capital is positive—that is, if the increase in current assets exceeds the increase in current liabilities—this amount is as much a cost to the project as is the cost of the asset itself. Thus, the project must be charged an amount additional to the cost of the new asset to reflect the net financing needed for the current asset accounts. Similarly, if the change in net working capital is negative, the project is generating a work- ing capital cash inflow because the increase in liabilities exceeds the project’s current asset requirements, and this cash flow partially offsets the cost of the asset being acquired.
As the project approaches termination, inventories will be sold off and not replaced, receivables will be converted to cash, and no new receivables will be created. In effect, the business will recover its investment in net work- ing capital when the project is terminated. This recovery will produce a cash flow that is equal, but opposite in sign, to the change in net working capital cash flow that arises at the beginning of a project.
For healthcare providers, the change in net working capital often is small and can be ignored without materially affecting the analysis. In addi- tion, because the initial change in net working capital is exactly offset at project termination, its impact is reduced. However, when a large project has a significant change in net working capital, failure to consider the net investment in current assets will result in an overstatement of the project’s profitability, which can lead to a faulty analysis.
Inflation Effects Inflation effects can have a considerable influence on a project’s profitability, so inflation must be considered in any sound capital budgeting analysis. As discussed in Chapter 9, a business’s corporate cost of capital is based on its costs of debt and equity, which in turn are estimated on the basis of investors’
Chapter 11: Capital Budgeting
required rates of return. Because investors must protect themselves against rhe loss of purchasing power as a result of inflation, they incorporate an infla- tion premium into their required returns. For example, a debt investor might require a 5 percent return on a ten-year bond in the absence of inflation. However, if inflation is expected to average 4 percent over the coming ten years, the investor would require a 9 percent return.
Because inflation effects are already embedded in the corporate cost of capital, and because this rate is the benchmark used to discount the cash flows in our profitability measures, it is necessary to ensure that inflation effects are a|so built into the project’s estimated cash flows. If cash flow estimates do not include inflation effects (real cash flows), and a discount rate that does include inflation effects is used (nominal discount rate), the profitability of the project will be biased downward (understated).
The most effective way to deal with inflation is to build inflation effects into each cash flow component using the best available information about how each component will be affected. For example, per procedure reimbursement rates may be expected to increase at a 4 percent rate, labor costs may be expected to increase at an 8 percent rate, supply costs may be expected to increase at a 2 percent rate, and so on. Because it is impossible to estimate future inflation rates with much precision, inflation sometimes is assumed to be neutral—that is, inflation is assumed to affect all revenues and costs, except depreciation, equally. However, such an assumption rarely reflects the actual situation facing healthcare businesses. So, in general, dif- ferent inflation rates should be applied to each cash flow component. Infla- tion adds to the uncertainty, or riskiness, of capital budgeting as well as to its complexity. Fortunately, spreadsheet programs are available to help with inflation analysis, so the mechanics of inflation adjustments are not difficult.
Cash Flow Estimation Bias As stated previously, cash flow estimation is the most critical, and the most difficult, part of the capital budgeting process. Cash flow components, such as volume and reimbursement rates, often must be forecasted many years into the future, and estimation errors are bound to occur, some of which can be large.1 However, large businesses evaluate and accept many projects every year, and as long as cash flow estimates are unbiased and the errors are random, the estimation errors will tend to offset one another—that is, some cash flow estimates will be too high and some will be too low. However, in the aggregate for all projects, the realized cash flows will be close to the esti- mates, so realized total profitability will be close to that expected.
Unfortunately, there are strong indications that capital budgeting cash flow forecasts are not unbiased; rather, managers tend to be overly optimistic in their forecasts. As a result, revenues tend to be overstated and costs tend
to be understated.2 The result is an upward bias in estimated profitabili This bias may occur because managers often are rewarded on the basis of 3 size of their divisions or departments, so they have an incentive to maximi2e the number of projects accepted rather than the profitability of the projects Managers also may be emotionally attached to their projects and become unable to objectively assess a project’s potential.
Top management can use two procedures to identify cash flow csti mation bias. First, if a project is judged to be highly profitable as compared to the business’s average project, this question should be asked: What is the underlying cause of this project’s high profitability? If the business has some underlying advantage—such as a monopoly position in a managed care market or a superior reputation in providing a specific service, such as organ transplants—there may be a logical rationale supporting the high profitability, If no such factor can be identified, senior management should be concerned about the possibility of estimation bias. Even when these factors exist, the project’s profitability will likely be eroded at some point in the future by competitive pressure from other businesses seeking to capture the high prof- itability inherent in the project.
Second, the post-audit process, which we discuss later in this chapter, will help to identify divisions and departments that habitually overstate or understate project profitability. (It is difficult to identify projects whose cash flows are understated because many of those projects will be rejected, and hence no cash flow comparisons can be made. When competing firms under- take projects of the type that are being rejected, we should be especially suspi- cious that underestimation bias is present.) Many firms now identify managers and divisions that typically submit biased cash flow estimates and compensate for this bias in the decision process by reducing cash inflows that are thought to be too rosy or by increasing the cost of capital to such projects.
Strategic Value In the previous section, we discussed the problem of cash flow estimation bias, which can cause a project’s profitability to be overstated. Another prob- lem that can occur in cash flow estimation is underestimation of a project’s true profitability. Underestimation results when a project’s strategic value— the value of future investment opportunities that can be undertaken only if the project currently under consideration is accepted—is not recognized.
For example, consider a hospital management company analyzing a management contract for a hospital in Hungary, which would be its first move into Eastern Europe. On a stand-alone basis, this project might be unprofitable, but the project might provide entry into the Eastern Euro- pean market, which would likely unlock the door to a whole range of highly
profitable new projects. For another example, consider Ridgeland’s decision to start a kidney transplant program. The financial analysis of this project showed the program to be unprofitable, but Ridgeland’s managers consid- ered kidney transplants to be the first step in an aggressive transplant program that would not only be profitable in itself but also enhance the hospital’s reputation for technological and clinical excellence and thus contribute to the hospital’s overall profitability.
In theory, the best approach to dealing with strategic value is to fore- cast the cash flows from follow-on projects, estimate their probabilities of occurrence, and then add the expected cash flows from the follow-on proj- ects to the cash flows of the project under consideration. In practice, this is usually impossible to do—either the follow-on cash flows are too nebulous to forecast or the potential follow-on projects are too numerous to quantify. In most situations, the strategic value of a project stems from the options inher- ent in it. Thus, at a minimum, decision makers must recognize that some projects have strategic value, and this value should be qualitatively considered when making capital budgeting decisions.
Strategic value is but one type of added value that arises when projects have embedded in them options that may or may not be exercised (taken advantage of) in the future. Options that are inherent in projects, as opposed to options on securities, are called rtcd, or ma/na-gericd, options. In the next chapter, we further discuss real options and their implications for a project’s risk and value.
1. Briefly discuss the following concepts associated with cash flow estimation: a. Incremental cash flow b. Cash flow versus accounting income c. Cash flow timing d. Project life e. Sunk costs f. Opportunity costs g. Effects on other projects h. Shipping and installation costs i. Changes in net working capital j. Inflation effects k. Cash flow estimation bias l. Strategic value
SELF-TEST QUESTION
482 Understanding Healthcare Finance Management
On the web at: ache.org/books/
UHFM7
Cash Flow Estimation Example
Up to this point, we have discussed a number of key concepts related to cash flow estimation. In this section, we present an example that illustrates some of the concepts already covered and introduces several others that are impor- tant to good cash flow estimation.
The Basic Data Consider the situation facing Ridgeland in its evaluation of a new MRI (magnetic resonance imaging) system. The system costs $1.5 million, and the hospital would have to spend another $1 million on shipping, site prepara- tion, and installation. Because the system would be installed in the hospital, the space to be used has a very low, or zero, market value to outsiders, so no opportunity cost has been assigned to account for the value of the space.
The MRI site is estimated to generate weekly usage (volume) of 40 scans, and each scan would, on average, cost the hospital $15 in supplies. The site is expected to operate 50 weeks per year, with the remaining two weeks devoted to maintenance. The estimated average charge per scan is $500, but 25 percent of this amount, on average, is expected to be lost to indigent patients, contractual allowances, and bad-debt losses. Thus, the average net revenue expected from each scan is $375. Ridgeland’s managers developed the project’s forecasted revenues by conducting the revenue analysis con- tained in Exhibit 11.1.
The MRI site would require two technicians, prompting an incremen- tal increase in annual labor costs of $50,000, including fringe benefits. Cash overhead costs would increase by $10,000 annually if the MRI site is acti- vated. The equipment would require maintenance, which would be furnished
EXHIBIT 11.1 Ridgeland
Community Hospital: MRIPayer
Number of Scans
per Week
Charge per Scan Total
Charges Basis of Payment
Net Payment per Scan
Total Payment
s Site RevenueMedicare 10 $500 $ 5,000 Fixed fee $370* $ 3.700
AnalysisMedicaid 5 500 2,500 Fixed fee 350* 1,750 Private insurance 9 500 4.500 Full charge 500 4,500 Blue Cross 5 500 2,500 % of charge 420* 2,100 Managed care 7 500 3.500 % of charge 390* 2,730 Self-pay 4 500 2,000 Full charge 55** 220 Total 40 $20,000 $15,000
Average $ 500 $ 375
*Net of contractual allowances **Net of bad-debt losses
r Chapter 11: Capital Budgeting 483 by the manufacturer for an annual fee of $150,000, payable at the end of each year of operation. For book (financial statement) purposes, the MRI site would be depreciated by the straight-line method over a five-year life.
The MRI site is expected to operate for five years, at which time the
hospital’s master plan calls for a brand-new imaging facility. The hospital plans to sell the MRI system at that time for an estimated $750,000 salvage value, net of removal costs. The inflation rate is estimated to average 5 per- cent over the period, and this rate is expected to apply to all revenues and costs except depreciation. Ridgeland’s managers initially assume that projects under evaluation have average risk; thus, the hospital’s 10 percent corporate cost of capital is the appropriate project cost of capital. In Chapter 12, we demonstrate that a risk assessment of the project may indicate that a different cost of capital is appropriate.
Although the MRI project is expected to draw some patients from the hospital’s other imaging systems, new MRI patients are expected to gener- ate revenues for some of the hospital’s other departments. On net, the two effects are expected to balance out—that is, the cash flow gain from other services used by the new MRI patients is expected to offset the cash flow loss from other imaging systems.
Cash Flow Analysis The first step in the financial analysis is to estimate the MRI site’s net cash flows. This analysis is presented in Exhibit 11.2. Here are the key points of the analysis by line number:
• Line 1. Line 1 contains the estimated cost of the MRI system. In general, capital budgeting analyses assume that the first cash flow, normally an outflow, occurs at the end of Year 0. Note that expenses, or cash outflows, are shown in parentheses.
• Line 2. The related shipping, site preparation, and installation expense—$1 million—is also assumed to occur at Year 0.
• Line 3. Gross revenues = Weekly volume x Weeks of operation x Charge per scan = 40 x 50 x $500 = $1,000,000 in the first year. The 5 percent inflation rate is applied to all charges and costs that would likely be affected by inflation, so the gross revenue amount shown in line 3 increases by 5 percent over time. Although most of the operating revenues and costs would occur more or less evenly over the year, it is difficult to forecast exactly when most of the flows would occur. Furthermore, there is significant potential for large errors in cash flow estimation. For these reasons, operating cash flows are often assumed to occur at the end of each year. Also, we assume that the MRI system could be put into operation quickly. If this were not the case, the first year’s operating flows would be reduced because it would be a partial
00 4>
EXHIBIT 11.2 Ridgeland Community Hospital: MRI Site Cash Flow Analysis
Annual Cash Flows
o 1 2 3 1. System 2. Related expenses 3. Gross revenues 4. Deductions 5. Net revenues 6. Labor costs 7. Maintenance costs 8. Supplies 9. Incremental overhead 10. Depreciation 11. Operating cash flow 12. Taxes 13. Net operating cash flow 14. Depreciation 15. Net salvage value 16. Net cash flow
($1,500,000) (1,000,000)
$1,000,000 250,000
Note: Calculations are rounded.
$ 750,000 50,000
150,000 30,000 10,000
350,000 $ 160,000
0 $160,000
350,000
($2,500,000) $ 510,000
$1,050,000 $1,102,500 $1,157,625 $ 1,215,506 262,500 275,625 289,406 303,877
$ 787,500 $ 826,875 $ 868,219 $ 911,630 52,500 55,125 57,881 60,775
157,500 165,375 173,644 182,326 31,500 33,075 34,729 36,465 10,500 11,025 11,576 12,155
350,000 350,000 350,000 350,000 $ 185,500 $ 212,275 $ 240,389 $ 269,908
0 0 0 0 $ 185,500 $ 212,275 $ 240,389 $ 269,908
350,000 350,000 350,000 350,000 750,000
$ 535,500 $ 562,275 $ 590,389 $1,369,908
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Chapter 11: Capital
year of operations. In some situations, it might take several years from the first cash outflow to the point where the project is operational and begins to generate operating cash inflows. Line 4. Deductions from charges are estimated to average 25 percent of gross revenues, so in Year 1, 0.25 x $1,000,000 = $250,000 of gross revenues would be uncollected. This amount increases each year by the 5 percent inflation rate. Line 5. Line 5 contains the net revenues in each year, Line 3 - Line 4. An alternative format for the cash flow analysis would be to replace lines 3, 4, and 5 with a single line that shows Net revenues = Weekly volume x Weeks of operation x Net charge per scan, which for the first year would be 40 x 50 x $375 = $750,000. Line 6. Labor costs are forecasted to be $50,000 during the first year but will increase over time at the 5 percent inflation rate. Line 7. Maintenance fees must be paid to the manufacturer at the end of each year of operation. These fees are assumed to increase at the 5 percent inflation rate. Line 8. Each scan uses $15 of supplies, so supply costs in the first year total 40 x 50 x $15 = $30,000, which are expected to increase each year by the inflation rate. Line 9. If the project is accepted, overhead cash costs will increase by $10,000 in the first year. Note that the $10,000 in cash costs is related directly to the acceptance of the MRI project. Existing overhead costs that are arbitrarily allocated to the MRI site are not incremental cash flows and thus should not be included in the analysis. Overhead costs are also assumed to increase over time at the inflation rate. Line 10. For book purposes, depreciation in each year is calculated by the straight-line method, assuming a five-year depreciable life. The depreciable basis is equal to the capitalized cost of the project, which includes the cost of the asset and related expenses, less the estimated salvage value. Thus, the depreciable basis is ($1,500,000 + $1,000,000) - $750,000 = $1,750,000. Then, the straight-line depreciation in each year of the project’s five-year depreciable life is (1/5) x $1,750,000 = $350,000. Note that depreciation is based solely on acquisition costs, so it is unaffected by inflation. Also, note that the cash flows in Exhibit 11.2 are presented in a generic format that can be used by both investor-owned and not-for-profit hospitals. Depreciation expense is not a cash flow but an accounting convention that prorates the cost of a long-term asset over its productive life. Because Ridgeland is tax exempt, depreciation will not affect taxes, and because depreciation is added back to the cash flows in line 14, depreciation can be totally omitted from the cash flow analysis.
486 Understanding Healthcare Finance Management
• Line 11. Line 11 shows the project’s operating cash flow in each year which is merely net revenue less all operating expenses.
• Line 12. Line 12 contains zeros because Ridgeland is a not-for-profit hospital and hence does not pay taxes.
• Line 13. Ridgeland pays no taxes, so the project’s net operating cash flow equals its operating cash flow.
• Line 14. Because depreciation—a noncash expense—was deducted in line 10, it must be added back to the project’s net operating cash flow in each year to obtain each year’s net cash flow.
• Line 15. Finally, the project is expected to be terminated after five years, at which time the MRI system will be sold for an estimated $750,000. This salvage value cash flow is shown in line 15 as an inflow at the end of Year 5.
• Line 16. The project’s net cash flows are shown in line 16. The project requires a $2.5 million investment at Year 0 but then generates cash inflows over its five-year operating life.
Note that the Exhibit 11.2 cash flows do not include any allowance for interest expense. On average, Ridgeland will finance new projects in accordance with its target capital structure, which consists of 50 percent debt financing and 50 percent equity (fund) financing. The costs associated with this financing mix, including interest costs, are incorporated into Ridgeland’s corporate cost of capital of 10 percent. Because the cost of debt financing is included in the discount rate that will be applied to the cash flows, we would be counting interest expense twice if we also incorporated it into the cash flow estimates.
Taxable Organizations The cash flow analysis in Exhibit 11.2 can be easily modified to reflect tax implications if the analyzing firm is taxable. For example, assume that the MRI project is being evaluated by Ann Arbor Health Care Inc., an investor- owned hospital chain. Furthermore, assume that all of the project data presented earlier apply to Ann Arbor, except that (1) the MRI falls into the Modified Accelerated Cost Recovery System (MACRS) five-year class for tax depreciation and (2) the firm has a 40 percent tax rate. Exhibit 11.3 contains Ann Arbor’s cash flow analysis. Note the following differences:
• Line 10. First, depreciation expense must be modified to reflect tax depreciation rather than book depreciation. As discussed in Chapter 1, tax depreciation is calculated using the MACRS. To determine the MACRS depreciation allowance in any year, multiply the asset’s depreciable basis (without considering its estimated salvage value)
■ Chapter 11: Capital Budgeting 487
by the appropriate depreciation factor. In the MRI illustration, the depreciable basis is $2.5 million, and the MACRS factors for the five- year class are 0.20, 0.32, 0.19, 0.12, 0.11, and 0.06 in years 1 to 6, respectively. Thus, the tax depreciation in Year 1 is 0.20 x $2,500,000 = $500,000; in Year 2 the depreciation is 0.32 x $2,500,000 = $800,000; and so on.
• Line 12. Taxable businesses must reduce the operating cash flow in line 11 by the amount of taxes. Taxes, which appear in line 12, are computed by multiplying the pretax operating cash flow in line 11 by the business’s marginal tax rate. For example, the project’s taxes for Year 1 are 0.40 x $10,000 = $4,000. Note that the taxes shown for Year 2 are a negative $105,800. In this year, the project is expected to lose $264,500, so Ann Arbor’s taxable income, assuming its existing projects are profitable, will be reduced by this amount if the project is undertaken. This reduction in taxable income would lower the
firm’s tax bill by T x Taxable income reduction = 0.40 x $264,500 = $105,800?
• Line 14. The MACRS depreciation amount, because it is a noncash expense, is added back on line 14.
• Line 15. Investor-owned firms normally incur a tax liability on the sale of a capital asset at the end of the project’s life. According to the Internal Revenue System (IRS), the value of the MRI system at the end of Year 5 is the tax book value, which is the depreciation that remains on the tax books. In the illustration, five years’ worth of depreciation would be taken, so only one year of depreciation remains. The MACRS factor for Year 6 is 0.06, so by the end of Year 5, Ann Arbor has expensed 0.94 of the MRI’s depreciable basis and the remaining tax book value is 0.06 x $2,500,000 = $150,000. Thus, according to the IRS, the value of the MRI system is $150,000. When Ann Arbor
sells the system for its estimated salvage value of $750,000, it realizes a “profit” of $750,000 - $150,000 = $600,000 and must repay the IRS an amount equal to 0.4 x $600,000 = $240,000. The $240,000 tax bill recognizes that Ann Arbor took too much depreciation on the MRI system, so it is a recapture of the excess tax benefit taken over the five-year life of the system. The $240,000 in taxes reduces the cash received from the sale of the MRI equipment, so the salvage value net of taxes is $750,000 - $240,000 = $510,000.
As can be seen by comparing line 16 in exhibits 11.2 and 11.3, all else same, the taxes paid by investor-owned firms tend to reduce a project’s
net operating cash flows and net salvage value and hence reduce the project’s Profitability.
the
00 00
EXHIBIT 113 Ann Arbor Health Care: MRI Site Cash Flow Analysis
Annual Cash Flows
2 3 4 5 1. System 2. Related expenses 3. Gross revenues 4. Deductions 5. Net revenues 6. Labor costs 7. Maintenance costs 8. Supplies 9. Incremental overhead 10. Depreciation 11. Operating cash flow 12. Taxes 13. Net operating cash flow 14. Depreciation 15. Net salvage value 16. Net cash flow
($ 1,500,000) (1,000,000)
$1,000,000 250,000
$ 750,000 50,000
150,000 30,000 10,000
500,000 $
0 0 0
0 <D
q0'
$ 6,000 500,000
($2,500,000) $ 506,000
$1,050,000 $1,102,500 $1,157,625 $1,215,506 262,500 275,625 289,406 303,877
$ 787,500 $ 826,875 $ 868,219 $ 911,630 52,500 55,125 57,881 60,775 157,500 165,375 173,644 182,326 31,500 33,075 34,729 36,465 10,500 11,025 H,576 12,155 800,000 475,000 300,000 275,000
($ 264,500) $ 87,275 $ 290,389 $ 344,908 (105,800) 34,9io 116,156 137,963
($ 158,700) $ 52,365 $ 174,233 $ 206,945 800,000 475,ooo 300,000 275,000
510,000 $ 641,300 $ 527,365 $ 474,233 $ 991,945
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Note: Calculations are rounded.
Chapter 11: Capital Budgeting 489
Replacement Analysis \Vc used Ridgeland’s MRI project to illustrate how the cash flows from jn expansion Pr°ject are analyzed. All businesses, including Ridgeland, also make repla-cement decisions, which consider acquiring a new asset to replace an existing asset that could, if not replaced, continue in operation. The cash t]ow analysis for a replacement decision is somewhat more complex than that for an expansion decision because the cash flows from the existing asset must be considered.
Again, the key to cash flow estimation is to focus on the incremental cash flows. If the new asset is acquired, the existing asset can be sold, so the current market value of the existing asset is a cash inflow at time 0 in the analysis. The incremental flows are the cash flows expected from the replace- ment asset less the flows that the existing asset produces. By applying the incremental cash flow concept, we can estimate the correct cash flows for replacement decisions.
1. Briefly describe how a project cash flow analysis is constructed. 2. Is it necessary to include depreciation expense in a cash flow
analysis for a not-for-profit provider? Explain your answer. 3. What are the key differences between cash flow analyses performed
by investor-owned and not-for-profit organizations? 4. How do expansion and replacement project analyses differ?
SELF-TEST QUESTIONS
Breakeven Analysis
Breakeven analysis is used to gain insights into the potential profitability and risk of a project. Furthermore, breakeven analysis often is useful in evaluating operational decisions that do not require an initial capital investment, such as expanding the hours of a clinic. Although breakeven analysis can be applied in many different ways, we focus here on two types of breakeven: (1) utiliza- tion (volume) breakeven and (2) time breakeven (payback).
Utilization (Volume) Breakeven For an illustration of utilization breakeven, first consider how it can be applied to operating cash flows. Specifically, let’s examine operating break- even in Year 1. From Exhibit 11.2, we know that 40 scans per week would produce a net cash flow in Year 1 of $510,000. How many scans per week would be necessary to reach operating breakeven in Year 1? In other words, how many scans per week are required to generate a positive net cash flow *n Year 1 ? Exhibit 11.4 contains the Year 1 net cash flow at different utiliza- tIOn levels. As indicated by the data, the project breaks even in Year 1 if the
490 Understanding Healthcare Finance Management
EXHIBIT 11.4 Ridgeland Number of Scans per Week
Community 0 Hospital: MRI 5
Site Year 1 10 Breakeven 11
Analysis
^20,OOo) (30,000) (12,000)
6,000 24,000 42,000 60,000
150,000 33o,ooo 510,000
13 14 15 20 30 40
hospital performs 12 scans per week. Of course, the actual analysis typically would be performed using a spreadsheet model.
Utilization breakeven can also be applied to the entire project. Here, we want to know the answer to this question: What weekly utilization would allow the hospital to break even economically—that is, to recover all of the costs asso- ciated with the project, including capital costs? When the analysis is modeled on a spreadsheet, answers to these types of questions are easy to obtain. As we dis- cuss in a later section, economic breakeven occurs when a project’s net present value equals zero or just turns positive. In Ridgeland’s MRI project, economic breakeven occurs at a weekly volume of 39 scans, so the project in its entirety just breaks even when the hospital averages 39 scans per week over the five-vear forecasted life of the project. Such information is clearly useful to Ridgeland's managers. If they feel strongly that utilization will exceed 39 scans per week, it is highly likely that the project will be economically profitable. Conversely, if they believe that utilization will be less than the breakeven level, the project will probably be unprofitable. Also, if, as in this situation, the projected volume is just above breakeven, a small forecasting error can make a project appear profit- able on paper when, in reality, it would be unprofitable if undertaken.
This type of breakeven analysis can be applied to cash flow inputs other than volume. For example, it would be useful for Ridgeland’s managers to know the project’s breakeven salvage value. Using a spreadsheet, we can easily use trial and error (or even more easily use Excel’s Goal Seek capabil- ity) to find the economic breakeven point for salvage value: about $617,000. Thus, even if the MRI is worth only $617,000 at the end of five years as opposed to the actual estimate of $750,000, the project remains financially worthwhile (or at least neutral).
Time Breakeven (Payback) The payback., or payback period, measures time breakeven. Payback is defined
as the expected number of years required to recover the investment in the
Chapter 11: Capital Budgeting 491
project. For an illustration, consider the net cash flows for the MRI project contained in Exhibit 11.2. The best way to determine the project’s payback is to construct the project’s cumulative cash flows as shown in Exhibit 11.5. Here, the cumulative cash flow in each year is the sum of the annual cash flows up to and including that year. For example, the cumulative cash flow in Year 2 is -$2,500,000 + $510,000 + $535,500 = -$1,454,500.
Because the cumulative cash flows turn positive in Year 5, the $2.5 million investment in the MRI site would be recovered some time during Year 5- If the project’s cash flows are assumed to come in evenly during the year, breakeven would occur $301,836/$l,369,908 = 0.22 of the way through Year 5, so the payback is 4.22 years.
Many years ago, managers used payback as the primary financial evaluation tool in project analyses. For example, a business might accept all projects with paybacks of less than five years. However, payback has two serious deficiencies when it is used as a project selection criterion. First, pay- back ignores all cash flows that occur after the payback period. For example, assume that Ridgeland is evaluating a competing project that has the same cash flows as the MRI project in years 0 through 5. However, the alternative project has a cash inflow of $2 million in Year 6. Both projects would have the same payback, 4.22 years, and hence be ranked the same, even though the alternative project clearly is better from a financial perspective. Second, payback ignores the opportunity costs associated with the capital employed. For these reasons, payback generally is no longer used as the primary evalu- ation tool.
However, payback is useful in capital investment analysis. The shorter the payback, the more quickly the funds invested in a project become avail- able for redeployment in the organization, and hence the more liquid the project. Also, cash flows expected in the distant future are generally more dif- ficult to forecast than near-term cash flows, so projects with shorter paybacks generally are less risky than those with longer paybacks. Therefore, payback is often used as a rough measure of a project’s liquidity and risk.
Another measure, the discounted payback, is similar to the “regular” pay- back, except that the cash flows in each year are discounted by the project’s cost
EXH I BIT 11.5 Year Annual Cash Flow Cumulative Cash Flow Ridgeland
0 ($2,500,000) ($2,500,000) Community 1 510,000 (1,990,000) Hospital: MRI 2 535.500 (1,454,500) Site Cumulative 3 562,275 (892,225) Cash Flows 4 590,389 (301,836) 5 1,369,908 1,068,072
Paybac k = 4 + $301,836/51,369,908 = 4.22 years.
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492
EXHIBIT 11.6
Ridgeland Community
Hospital: MRI Site
Cumulative Discounted Cash Flows
Year
Annual Cash Flow
Discounted Cash Flow
0 ($2,500,000) ($2,500,000) 1 510,000 463,636 2 535,500 442,562 3 562,275 422,446 4 590,389 403,244 5 1,369,908 850,605
Cumulative Discourit Cash Flow
($2,500,000) (2,036,364) (i .593,802) (1,i7i,356) (768,112)
82,493
Discounted payback = 4 + 768,112/850,605 = 4.90 years.
of capital before the payback is calculated. Thus, discounted payback solves the regular payback’s problem of not considering the project’s cost of capital in the payback calculation. For an illustration of discounted payback, consider Exhibit 11.6. Here, we have created a new column labeled Discounted Cash Flow. Each entry in this column is the matching annual cash flow discounted at the 10 percent cost of capital for the number of years it occurs into the future. For example, the discounted Year 2 cash flow is $535,500/(1TO)2 = $442,562. The discounted payback is 4 + (768,112/850,605) = 4.90 years. Because time value is recognized in the discounted payback, it is longer than the regular payback of 4.22 years.
SELF-TEST QUESTIONS 1. Why is breakeven information valuable to decision makers?
2. Describe several types of breakeven analysis. 3. What is the difference between regular payback and discounted
payback?
Return on Investment Analysis
Up to this point, the chapter has focused on cash flow estimation and break- even analysis. Perhaps the most important element in a project’s financial analy- sis is expected profitability, which generally is assessed by return on investment (ROI) measured either in dollars or in percentage rate of return. In the next sections, we present one dollar measure (net present value) and two rate-of- return measures (internal rate of return and modified internal rate of return).
Net Present Value Net present value (NPV) is a profitability measure that uses the discounted cash flow (DCF) techniques discussed in Chapter 4, so it is often referred to as a DCF measure. To apply the NPV method, we proceed as follows:
Chapter 11: Capital Budgeting 493
• Find the present (time 0) value of each net cash flow, including inflows and outflows, discounted at the project cost of capital.
• Sum the present values. This sum is the project’s NPV. • If the NPV is positive, the project is profitable, and the higher the NPV,
the more profitable the project. If the NPV is zero, the project breaks even in terms of profit. If the NPV is negative, the project is unprofitable.
Assuming a project cost of capital of 10 percent, the NPV of Ridge- land’s MRI project is calculated as follows:
($2,500,000) $510,000 $535,500 $562,275 $590,389 $1,369,908
Spreadsheets have NPV functions that easily perform the mathematics given the cash flows and cost of capital.4 Here is one example of a spreadsheet calculation for the project:
» B C D— 1 2 10.0% Project cost of capital
3 $(2,500,000) Cash flow 0 A 510,000 Cash flow 1 5 535,500 Cash flow 2 6 562,275 Cash flow 3
7 590,389 Cash flow 4 8 1,369,908 Cash flow 5
9
10 $82,493 =NPV(A2,A4:A8)+A3 (entered into cell A10)
Note that we have merely entered the net cash flows into the spread- sheet. In a typical project analysis, the spreadsheet would be used for the entire cash flow analysis, with the last line of the cash flows being the net cash flows. The project’s NPV is calculated in cell A10 using the NPV func- tion. The first entry in the function (A2) is the discount rate (project cost of capital), while the second entry (A4:A8) designates the range of cash flows from years 1 through 5. Because the NPV function calculates NPV one period before the first cash flow entered in the range, it is necessary to start the range with Year 1 rather than Year 0. Finally, to complete the calculation
in cell A10, A3 (the initial outlay) is added to the NPV function. The result—$82,493—is displayed in cell A10.
The rationale behind the NPV method is straightforward. An NPV of zero signifies that the project’s cash inflows are just sufficient to (1) return the capital invested in the project and (2) provide the required rate of retu on that invested capital. In other words, the project just breaks even in an economic sense, which considers all costs associated with the employment of capital. If a project has a positive NPV, it is generating excess cash flow s and these excess cash flows are available to management to reinvest in the' firm and, for investor-owned firms, to pay bonuses or dividends. In investor- owned businesses, NPV is a direct measure of the project’s contribution to owners’ wealth. If a project has a negative NPV, its cash inflows are insuf- ficient to compensate the business for the capital invested or perhaps will not ever recover the invested capital, so the project is unprofitable and acceptance would cause the financial condition of the business to deteriorate.
The NPV of the MRI project is $82,493, so on a present value basis the project is projected to generate a cash flow excess of more than $80,000. Thus, the project is economically profitable, and its acceptance would have a positive impact on Ridgeland’s financial condition.
Internal Rate of Return Whereas NPV measures a project’s dollar profitability, internal rate of return (IRR)—which is another DCF profitability measure—measures a project’s percentage profitability or expected rate of return. Mathematically, the IRR is defined as the discount rate that equates the present value of the project’s expected cash inflows to the present value of the project’s expected cash outflows, so the IRR is simply the discount rate that forces the NPV of the project to equal zero.
For Ridgeland’s MRI project, the IRR is the discount rate that causes the sum of the present values of the cash inflows to equal the $2.5 million cost of the project:
($2,500,000) $510,000 $535,500 $562,275 $590,389 $1,369,908 495.046 4 -----1 I 433.842 ◄ --------------------1 410,021 4 -------------------------------------- 387,509 ◄ ----------------------------------------------------- 809,321 ◄ ---------------------------------------------------------------------
($ 261) « $0 = NPV
When all of the MRI project’s cash flows are discounted at 11.1 per' cent, the NPV of the project is approximately zero. Thus, the MRI project’s
IRR is H-1 percent. Put another way, the project is expected to generate an H 1 percent rate of return on its $2.5 million investment.
Spreadsheets have IRR functions that calculate IRRs rapidly. Simply input the project’s cash flows into the spreadsheet and compute the IRR:
r --F" A B C D
$(2,500,000) Cash flow 0
510,000 Cash flow 1 535.500 Cash flow 2
562,275 Cash flow 3 590,389 Cash flow 4
1.369,908 Cash flow 5
11.1% =IRR(A2:A7) (entered into cell A9)
The entry in the IRR function (A2:A7) specifies the range of cash flows to be used in the spreadsheet calculation. The answer—11.1 percent— is displayed in cell A9.
If the IRR exceeds the project cost of capital, a surplus remains after recovering the invested capital and paying for its use, and this surplus accrues to the firm’s stockholders (in Ridgeland’s case, to its stakeholders). On the other hand, if the IRR is less than the project cost of capital, taking on the project imposes a cost on the firm’s stockholders or stakeholders. The MRI project’s 11.1 percent IRR exceeds the project’s 10 percent cost of capital. Thus, as measured by the IRR, the MRI project is profitable and its accep- tance would enhance Ridgeland’s financial condition.
Comparison of the NPV and IRR Methods Consider a project with a zero NPV. In this situation, the project’s IRR must equal its cost of capital. The project has zero profitability, and acceptance would neither enhance nor diminish the firm’s financial condition. To have a positive NPV, the project must have an IRR that is greater than its cost of capital; a nega- tive NPV signifies a project with an IRR that is less than its cost of capital. Thus, projects deemed profitable by the NPV method will also be deemed profitable by the IRR method. In the MRI example, the project would have a positive NPV for all costs of capital less than 11.1 percent. If the cost of capital is greater than 11.1 percent, the project would have a negative NPV. In effect, the NPV and IRR are perfect substitutes for one another in estimating whether a project is profitable.
Modified Internal Rate of Return In general, academics prefer the NPV profitability measure. This preference stems from two factors: (1) NPV measures profitability in dollars, which is a direct measure of the project’s contribution to the value of the business, and (2) both the NPV and IRR methods—because they are discounted cash flow
496 Understanding Healthcare Finance Management
Accounting Rate of Return The accounting rate of return (ARR) uses account- ing information to measure the profitability of an investment. Although there are alternative ways of performing the calculation, the generic formula is as follows:
Accounting rate of return = Average net profit/Average investment.
Here, both profit and investment are mea- sured in accounting terms and averaged over the life of the project. For example, a five-year project that cost $100,000 and has a zero salvage value would have an average investment of $100,000/5 = $20,000. If the aggregate profit over the 5 years was forecast to be $25,000, the average annual net profit would be $5,000. Thus, the proj- ect’s ARR would be $5,ooo/$2o,ooo = 25%.
Proponents of the ARR cite the following advantages:
1. It is simple to use and understand. 2. It can be readily calculated from
accounting data, unlike NPV and IRR. 3. It incorporates the entire stream of
income as opposed to looking at only a single year.
What is your opinion of the ARR? Does it have any weaknesses compared to NPV and IRR? Should healthcare organizations use ARR to make capital budgeting decisions?
be replaced by capital having this cost. Thus, in general, reinvestment at the cost of capital is a better assumption than reinvestment at the IRR rate, so NPV is theoretically a better measure of profitability than IRR is.5
Even though academics strongly favor the NPV method, practicing managers prefer the IRR method because it is more intuitive for most people to analyze investments in terms of percentage rates of return than dollars of NPV. Thus, an alternative rate of return measure has been developed that eliminates the primary problem with the IRR method. This measure is the modified internal rate of return (MIR.R), and it is calculated as follows:
techniques—require an assumption the rate at which project cash flow reinvested, and the NPV method better assumption.
s can be has the
To better understand the seo point, consider the MRI project’s Year 2 cash flow of $535,500, as shown in FxhiS 11.2. The discounting process inherent in flJ NPV and IRR methods automatically assigjl a reinvestment rate to this cash flow—that is, both the NPV and IRR methods assume that Ridgeland has an opportunity to rein- vest the $535,500 Year 2 cash flow in other projects, and each method automatically assigns a reinvestment rate to this flow for years 3, 4, and 5. The NPV method assumes reinvestment at the project cost of capital (10 percent), while the IRR method assumes reinvestment at the IRR rate (11.1 percent). Which is the better assumption—reinvest- ment at the cost of capital or reinvestment at the IRR rate? Typically, a business will take on all projects that exceed its cost of capital. Thus, at the margin, the returns from capital reinvested in the firm are more likely to be at, or close to, the cost of capital than at the project’s IRR, especially for projects with exceptionally high or low IRRs. Further- more, a business can obtain outside capital at a cost roughly equal to the cost of capital, so cash flows generated by a project could
Discount all the project’s net cash outflows back to Year 0 at the project cost of capital. This value is called the present value of costs.
• Compound all the project’s net cash inflows forward to the last (terminal) year of the project, at the project cost of capital. This value is called the inflow terminal value.
• The discount rate that forces the present value of the inflow terminal value to equal the present value of costs is defined as the MIRR.
Applying these steps to Ridgeland’s MRI project produces a MIRR of about 10.7 percent:
012345 I ________I __________I _________I _________I --------------1
($2,500,000) $510,000 $535>5OO $562,275 $590,389 $1,369,908 > 649,428 > 680,353 > 712,750 » 746,691
« $2,500,000 4 --------------------------“ ------------------------------- $4,159,130 -- ------------- @10.7% --------------
@10%
By compounding the cash inflows forward at 10 percent, the MIRR method forces the reinvestment rate to equal 10 percent, which is the project cost of capital. Note that the MIRR for the MRI project is less than the proj- ect’s IRR because the cash inflows are reinvested at only 10 percent rather than at the project’s 11.1 percent IRR. In general, the MIRR is less than the IRR when the IRR is greater than the cost of capital, but it is greater than the IRR when the IRR is less than the cost of capital. In effect, the IRR overstates the profitability of profitable projects and understates the profit- ability of unprofitable projects. By forcing the correct reinvestment rate, the MIRR method provides decision makers with a theoretically better measure of a project’s expected rate of return than does the IRR.
Here is the spreadsheet solution for MIRR:
A B C D 1 2 10.0% Project cost of capital 3 $(2,500,000) Cash flow 0 4 510,000 Cash flow 1 5 535.500 Cash flow 2
562,275 Cash flow 36
7 590.389 Cash flow 4
8 1,369,908 Cash flow 5 9
10 10.7% =MIRR(A3:A8,A2,A2) (entered into cell 10)
The MIRR function was placed in cell A10. The first entry in the function (A3:A8) is the range of cash flows, while the next two entries (A2yA2) are the
498 Understanding Healthcare Finance Management
project cost of capital. (The MIRR function allows the reinvestment rate to from the project cost of capital: The first of the two entries is the project c capital, and the second is the reinvestment rate. For our purposes, the two are the same.) The resulting MIRR—10.7 percent—is displayed in cell AlOf
In closing our discussion, note that use of the MIRR method has anotl advantage over the IRR method besides calculating the proper reinvest rate. Primarily, it is not subject to the problems that might occur when a projo has non-normal cash flows. A project with normal cash flows has one or mon outflows followed by one or more inflows, while one with non-normal cash flows has outflows occurring after one or more inflows have occurred. In the non-normal situation, it is possible for a project to have two IRRs or even to have no IRR. These unusual results occur because of the mathematics of the IRR calculation. Because the MIRR calculation is not subject to these problems it is the only rate-of-return measure available for some projects.6
SELF-TEST QUESTIONS 1. Briefly describe how to calculate NPV, IRR, and MIRR.
2. Explain the rationale behind each method. 3. Why is MIRR a better rate-of-return measure than IRR? 4. Do the three methods lead to the same conclusions regarding
project profitability? Explain your answer.
Some Final Thoughts on Breakeven and Profitability Analysis
We have presented several approaches to breakeven analysis and three profit- ability measures. In the course of our discussion, we purposely compared the methods against one another to highlight their relative strengths and weak- nesses, but in die process we may have created the impression that businesses would use only one method in the decision process. Today, virtually all capi- tal budgeting decisions of financial consequence are analyzed by computer; hence, it is easy to calculate and list numerous breakeven measures along with NPV, IRR, and MIRR. Because each measure contributes slightly different information about die financial consequences of a project, it would be foolish for decision makers to focus on a single financial measure. Thus, we believe that a thorough financial analysis of a new project should include numerous financial measures and that capital budgeting decisions are enhanced if all the information inherent in all of the measures is considered.
However, just as it would be foolish to ignore any of die quantitative measures, it would also be foolish to base capital budgeting decisions solely on these measures. The uncertainties in the cash flow estimates for many projects are such that the resulting quantitative measures can be viewed
Chapter 11: Capital Budgeting 499
only as rough estimates. Furthermore, organizational missions and strategic factors are important elements in capital budgeting decision making. Thus, qualitative factors should play an important role in the decision process. (We discuss one approach, project scoring, in a later section.)
Finally, as mentioned, managers should be cautious of potential proj- ects that have high expected profitability. In a highly competitive environ- ment, there would be no highly profitable projects available because the marketplace would have already identified these opportunities and taken advantage of them. Thus, high profitability projects must have some underly- ing rationale, such as market dominance or innovation, that justifies the profitability. Even then, under most circumstances, the project’s high profit- ability will be eroded over time by competition.
1. Should capital budgeting analyses look at only one breakeven or profitability measure? Explain.
2. Why should qualitative factors also play a role in capital budgeting decisions?
3. Why should projects that have high expected profitability be viewed with some skepticism?
Evaluating Projects with Unequal Lives
Occasionally, businesses must choose between two mutually exclusive projects that have unequal lives. (Two projects are mutually exclusive when accep- tance of one implies rejection of the other.) When this situation arises, if the project with the shorter life will be replicated in the future, an adjustment to the normal capital budgeting process is necessary. We now discuss two pro- cedures—(1) the replacement chain method and (2) the equivalent annual annuity method—to illustrate the problem and show how to deal with it.
Suppose American Dental Equipment Corporation is planning to modernize its production facilities and, as part of the process, is considering either installing a conveyor system (Project C) or using forklift trucks (Proj- ect F) to move materials from the parts department to the main assembly line. Exhibit 11.7 shows the expected net cash flows and the NPVs for these
two mutually exclusive alternatives. We see that Project C, when discounted at the firm’s 11.5 percent corporate cost of capital, has the higher NPV and thus appears to be the more profitable project.
Replacement Chain (Common Life) Method Although the analysis in Exhibit 11.7 suggests that Project C is the more profitable project, the analysis is incomplete and this conclusion is actually
SELF-TEST QUESTIONS
On the web at: ache.org/books/ UHFM7
500 Understanding Healthcare Finance Management
EXHIBIT 11.7 Expected Net Year Project C ^o/ectF Cash Flows for 0 ($40,000)
Projects C and F 1 8,000 ^$20,000)
7,oo o
2 14,000 13,000 3 13,000 12,000 4 12,000 — 5 11,000 6 10,000 -
NPV @11.5% $ 7.165 $ 5,391
incorrect. If the firm chooses Project F, it will have an opportunity to make a similar investment in three years, and if cost and revenue conditions con- tinue at the Exhibit 11.7 levels, this second, or replication, investment will also be profitable. However, if the firm chooses Project C, it will not have this second investment opportunity. Therefore, to make a proper comparison between the three-year and six-year projects, we can apply the replacement chain (common life) method—that is, find the extended NPV of Project F over a six-year period by assuming the project will be replicated, and then compare this extended NPV with the NPV of Project C over the same period.
The NPV for Project C, as calculated in Exhibit 11.7, is already over the six-year common life. For Project F, however, we must take three addi- tional steps: (1) determine the NPV of the replication project three years hence, (2) discount this NPV back to the present, and (3) sum the two components to obtain the project’s extended NPV. If we assume that the replication project will have the same cash flows as the original project, then Project F’s extended NPV is $9,280:
$5,391 $5,391 3.889 ◄ -----------------------------1
$9,280 = Extended NPV
Because Project F’s six-year (extended) NPV is greater than Project C’s six-year NPV, Project F is more profitable when the opportunity to rep- licate the project is considered.
Note that the time line analysis above uses NPVs to summarize Project F’s estimated cash flows. An alternative approach to the analysis is to place the annual cash flows on the time line:
r Chapter 11: Capital Budgeting 5012 3 4 5 6 ($20,000) $7,000 $13,000 $12,000
(20,000) $7,000 $13,000 $12,000 ($ 8,000)
NPV® $9,280.
Clearly, the former method is simpler. However, if the cash flows for the replicated project are not the same as the cash flows for the initial project, the more complex individual cash flow method must be used. By showing each cash flow, the analysis can accommodate changes in project cash flows that are expected to occur when the project is replicated.
Equivalent Annual Annuity Method Although the preceding example illustrates why an extended approach is necessary if two mutually exclusive projects with different lives are being analyzed, the analysis is generally more complex in practice. For example, one project might have a six-year life and the other a ten-year life. This compari- son would require a replacement chain analysis over 30 years, which is the lowest common multiple of the two lives. In such a situation, it is simpler to use the equivalent annual annuity (EAA) approach.
The EAA method involves three steps:
1. Find each project’s NPV over its original life. In Exhibit 11.7, we see that NPVC = $7,165 and NPVF = $5,391.
2. For each project, find the annuity (constant value) cash flow over the project’s original life that has the same present value as the project’s NPV. This cash flow is the EAA. Here is the concept shown on a time line for Project F:
0 1 2 3
EAA EAA EAA
11
$5,391 = NPVF
To find the value of EAAF on a financial calculator, enter 5,391 (or -5,391) as the PV, I = 11.5, and N = 3. Then, solve for PMT, which turns out to be 2,225. Thus, the EAA for Project F is $2,225.
502 Understanding Healthcare Finance Management
When discounted at the project cost of capital (11.5 percent) annuity stream over the original life of the project (three years) present value equal to Project F’s NPV ($5,391). The EAA for C—$1,718—is calculated in a similar manner. Thus, Project C has NPV that is equivalent to an annuity of $1,718 per year for six v while Project F’s NPV is equivalent to an annuity of $2,225 for three years.
3. Now, when projects are replicated—assuming that the cash flows remain the same—they earn the same NPV over and over, which is equivalent to replicating the project’s EAA over time. Thus, over any common life whether 6 years or 30 years, the project with the higher EAA will have I the higher NPV because its equivalent cash flow will be higher in every
year. Because Project F has the higher EAA, under the assumption of constant cash flow replication it is more profitable than Project C.
The EAA method is generally easier to apply, but the replacement chain method is often easier to explain to decision makers. Still, the two methods always lead to the same results if consistent assumptions are used. When should managers worry about unequal life analysis? As a general rule, the unequal life issue does not arise for independent projects; it is an issue only when mutually exclusive projects are being analyzed. However, even for mutually exclusive projects, it is not always appropriate to extend the analysis to a common life. Extension should be done only if there is a high probability that the projects will be replicated beyond their original lives.
Several weaknesses are inherent in the types of analyses just described. First, if inflation is expected, replacement cost will probably be higher than the initial cost and both revenues and operating costs will probably rise, so the static conditions built into the example would not be appropriate. Sec- ond, future replacements may use different technologies, which might also change the project’s replication cash flows. Third, it is difficult enough to estimate the lives of most projects, so estimations of the lives of a future series of projects are often just speculation.
In view of these problems, no experienced manager would be too con- cerned about comparing mutually exclusive projects with lives of, say, eight years and ten years. Given all of the uncertainties in the estimation process, such projects can, for all practical purposes, be assumed to have the same life. Still, it is important to recognize that a problem does exist if mutually exclu- sive projects that will be replicated have substantially different lives. When the managers of Ann Arbor encounter such problems, they build expected inflation, possible efficiency gains, or both directly into the cash flow esti- mates and then use the replacement chain approach to estimate the projects extended NPVs. The cash flow estimation is more complicated than in our example, but the concepts involved are the same.
1. Is it always necessary to adjust project cash flows to account for unequal lives?
2. Briefly describe the two methods for adjusting for unequal lives.
SELF-TEST QUESTIONS
Economic Life Versus Physical Life (Abandonment Value)
Customarily, projects are analyzed as though the business will operate the project over its full physical life. However, full-life operation may not be the best course of action financially; it may be best to terminate a project before the end of its potential life because doing so can materially affect a project’s estimated profitability. Termination of a project before the end of its physical life is called abandonment, and the key to making this decision is a project’s abandonment value. For example, consider Ridgeland’s proposal to establish a taxable medical transportation division that would offer specialized medical transportation services to Ridgeland’s patients and others in the community. The project’s cash flows are contained in Exhibit 11.8. For simplicity, we have shortened the physical life of the project to three years. The project’s investment and operating cash flows are shown in the second column, while the third column contains the project’s abandonment values. Abandonment values are equivalent to net salvage values, except they have been estimated for each year of the project’s physical life.
Using a 10 percent cost of capital, the NPV over the project’s three - year physical life, with zero abandonment value, is -$11,743. Thus, the project is unprofitable when the single alternative of a three-year life with a zero salvage value is considered. However, what would its NPV be if the project were abandoned after two years? In this situation, Ridgeland would receive operating cash flows for two years, plus the $190,000 abandonment value at the end of Year 2, and the project’s NPV would be $13,802. Thus, the project is profitable if Ridgeland operates it for only two years and then sells it. To complete the abandonment analysis, note that if the project were abandoned after one year, its NPV would be -$25,455.
feor Initial Investment and Operating Cash Flows
End of Year Net Abandonment Value
NPV if Abandoned at the End of the Year Listed
0 ($480,000) $480,000 $ 0 l 200,000 300,000 (25,455)
2 187,500 190,000 13,802 3 175,000 0 (n,743)
EXHIBIT 11.8 Medical Transportation Division’s Projected Cash Flows
^ote.- The project cost of capital is io percent.
The economic life of the project, which is the life that produces highest economic value (NPV), is two years. As a general rule, if profitably1
were the sole criterion in capital budgeting decisions, a project should b abandoned when the net abandonment value is greater than the present val C
of all cash flows beyond the abandonment point (discounted to the ab donment point). For example, if Ridgeland were to operate the division t< one year, the abandonment value at that point would be $300,000, but th" present value at Year 1 of the cash flows beyond Year 1 would be $187 Soo (1.10)1 + $190,000/(1.10)1 = $343,182, assuming abandonment at the end of Year 2. The Year 1 abandonment value is less than the Year 1 present value of continuing the project, so the project should not be abandoned at this point. However, a similar analysis at the end of Year 2 shows that the aban- donment value would be greater than the discounted value of future cash flows, so abandonment at Year 2 would produce the greater profitability. This conclusion is the same that we reached when calculating the NPVs of each possible project life. In essence, the abandonment decision involves compar- ing the abandonment cash flows to the cash flows associated with continuine the project to determine the most profitable course of action.
In this illustration, we examined the concept of abandonment by look- ing at a project in its initial evaluation stage. However, project performance should be examined on a regular basis, and those that are not meeting finan- cial goals should, if feasible, be abandoned. (Project performance is reviewed in the post-audit process, which we discuss in a later section.) Once a project is up and running, two different types of abandonment can occur: (1) sale b\ a business of a still-valuable product or service line because some other part} can operate the line more efficiently and (2) abandonment of a product or service line because it is losing money.
The first type can be illustrated by Ridgeland’s sale of its two walk-in clinics to a physician group. Although the clinics were profitable to Ridge- land, the physician group could presumably operate them more efficiently and hence was willing to pay the hospital a premium over the value the clinics would have if they remained under hospital control.
The second type of abandonment can be illustrated by Northeast Medical’s decision to discontinue its HMO (health maintenance organiza- tion) operation in Boston. Although Northeast’s GoodHealth plan hac proved profitable in several areas, competition in the Boston market provec destructive, so the firm decided to cut its losses.
SELF-TEST QUESTIONS 1. Define economic life, as opposed to physical life.
2. Should projects be viewed as having one fixed life, or should they be considered as having alternative lives?
Chapter 11: Capital Budgeting 505
Capital Budgeting in Not-for-Profit Businesses
although the capital budgeting techniques discussed up to this point are jppropnate for use by both investor-owned and not-for-profit businesses, a nor-for-pr°fit business has the additional consideration of meeting its chari- table mission. In this section, we discuss two models that extend the capital budgeting decision to not-for-profit firms.
yet Present Social Value Model Except for the discussion of strategic value, the financial analysis techniques discussed so far have focused exclusively on the cash flow implications of a proposed project. Some healthcare businesses, particularly not-for-profit providers, have the goal of producing social services along with commercial services. For such firms, the proper analysis of proposed projects must sys- tematically consider the social value of a project along with its pure financial, or cash flow, value.
When social value is considered, the total net present value (TNPV) of a project can be expressed as follows:7
Key Equation 11.1: Net Present Social Value Model TNPV = NPV + NPSV.
Here, NPV represents the conventional NPV of the project’s cash flow stream and NPSV is the net present social value of the project. The NPSV term, which represents managers’ assessment of the social value of the project in dollar terms, clearly differentiates capital budgeting in not-for-profit firms from that in investor-owned firms.
In evaluating each project, a project is acceptable if its TNPV is greater than or equal to zero. In other words, the sum of the project’s financial and social values is at least zero, so when both facets of value are considered, the project has positive (or at least non-negative) worth. Not all projects will have social value, but if a project does, it is considered formally in this decision model. However, no project should be accepted if its NPSV is negative, even ,f its TNPV is positive. Furthermore, to ensure the financial viability of the business, the sum of the NPVs of all projects initiated in a planning period must equal or exceed zero. If this restriction were not imposed, social value c°uld displace financial value over time, and a firm cannot continue to pro- v>de social value without maintaining financial integrity.
NPSV is the sum of the present (Year 0) values of each year’s social 'alue. In essence, the suppliers of fund capital to a not-for-profit firm never rcceive a cash return on their investment. Instead, they receive a return on
506 Understanding Healthcare Finance Management
The Three-Step Budgeting Process In today’s economic climate, hospitals are more strapped for cash than ever. Increasingly facing problems accessing the capital needed to finance new projects, hospitals’ capital budgeting deci- sions are becoming increasingly constrained. With limited capital, limited projects can be undertaken —meaning those that are put into play need to be carefully chosen, with an empha- sis on an objective, analytic decision-making process.
Unfortunately, rather than using a more rig- orous analysis, many organizations navigate the capital planning process by using a simple three- step budgeting process, which can be described as follows: (1) the total available capital is deter- mined; (2) department managers are asked to prioritize projects by A, B, and C levels; and (3) projects are approved in priority order until the funds are exhausted.
Based on what you have learned about capi- tal budgeting, can you think of some drawbacks to this approach? Further, can you think of why the methods described in this chapter might be superior to this process? Finally, understanding that the real world practice of healthcare financial management is often far removed from the theory behind it, can you think of some reasons some managers choose to use this process instead of a more sophisticated analysis?
Source: Information from Casolari and Womack (2010).
their investment in the form of social daL dends. These dividends take the forni services with social value to the CM, 1 ' . , . '-immu- nity, such as charity care, medical resear h and education, and myriad other services that (for one reason or another) do n pay their own way. A service provided t0 patient at a price equal to or greater than its cost does not create social value. Simi larly, if governmental entities purchase care directly for beneficiaries of a program or support research, the resulting social value is created by the payer and not by the pro- vider of the services.
In estimating a project’s NPSV, first it is necessary to estimate the social value of the services provided by the project in each year and to determine the discount rate to apply to those services. When a project provides services to individuals who are willing and able to pay for those services, the value of those services is captured by the amount they actually pay. Thus, the value of the services provided to those who cannot pay—or to those who cannot pay the full amount—can be estimated by the average net price paid by the individuals who are able to pay. This approach to valuing social services has intuitive appeal, but certain points merit further discussion:
• Price is a fair measure of value only if the payer has the capacity to judge the true value of the service provided. Many observers of the health services industry would argue that information asymmetries between the provider and the purchaser inhibit the purchaser’s ability’ to judge true value.
• Because most payments for healthcare services are made by third- party payers, price distortions may result. For example, insurers may be willing to pay more for services than an individual would pay in the absence of insurance, or the existence of monopsony power by
Chapter 11: Capital Budgeting 507
Medicare may result in a net price that is less than individuals would be willing to pay.
• A great deal of controversy exists over the true value of treatment in many situations. Suppose that some people are entitled to whatever healthcare is available, regardless of cost, and are not required to personally pay for the care. Even though society as a whole must cover the bill, people may demand a level of care that is of questionable value. For example, should $500,000 be spent to keep a comatose 92-year-old patient alive for a few more days? If the true value of such expenditure is zero, assigning a $500,000 value just because that is its cost makes little sense.
Despite these potential problems, it still seems reasonable to assign a social value to many—but not all—healthcare services on the basis of the price that others are willing to pay for those services.
The second requirement to estimating the NPSV of a project is to apply the discount rate to the annual social value stream. Like the required rate of return on equity for not-for-profit firms, there has been considerable (controversy over the proper discount rate to apply to future social values. However, contributors of fund capital clearly can capture social value two ways. First, as is commonly done, contributions can be made directly to not- for-profit organizations. Second, contributors can always invest the funds in a portfolio of securities and then use the proceeds to purchase the healthcare services directly. In the second situation, there would be no tax consequences on the portfolio’s return because the contributed proceeds would qualify for tax exemption, but the contributor would lose the tax exemption on the full amount of the funds placed in the portfolio. Because the second alternative exists, providers should require a return on their social value stream that approximates the return available on the equity investment in for-profit firms that offer the same services.
The NPSV model formalizes the capital budgeting decision process applicable to not-for-profit healthcare businesses. Although few organiza- tions actually attempt to quantify NPSV, not-for-profit providers should, at a minimum, subjectively consider the social value inherent in projects under consideration.
Project Scoring Approach Managers of not-for-profit businesses, as well as most managers of investor- owned businesses, recognize that nonfinancial factors should be considered in any capital budgeting analysis. The NPSV model examines only one other factor, and it is difficult to implement in practice. Thus, many firms use a
quasi-subjective project scoring approach to capital budgeting decisions that attempts to capture both financial and nonfinancial factors. Exhibit 1 j 9 illustrates one such approach, the project scoring matrix, used by Ridgeland
Ridgeland ranks projects on three dimensions: (1) stakeholder factors (2) operational factors, and (3) financial factors. Within each dimension' multiple factors are examined and assigned scores that range from 2 points for very favorable impact to -1 point for negative impact. The scores within each dimension are added to obtain scores for stakeholder, operational, and financial factors, and then the dimension scores are aggregated to obtain a total score for the project. The total score gives Ridgeland’s managers a fed for the relative values of projects under consideration when all factors, includ- ing financial, are taken into account.
Ridgeland’s managers recognize that the scoring system is completely arbitrary, so a project with a score of 16, for example, may be more or less than twice as good as a project with a score of 8. Nevertheless, use of the project scor- ing matrix forces managers to address multiple issues when making capital bud- geting decisions. Although Ridgeland’s approach should not be used at other organizations without modification for firm- and industry-unique circumstances, it does provide insight into how a firm-unique matrix might be developed.
SELF-TEST QUESTIONS 1. Describe the NPSV model of capital budgeting.
2. Describe the construction and use of a project scoring matrix.
The Post-Audit
Capital budgeting is not a static process. If there is a long lag between a proj- ect’s acceptance and its implementation, any new information concerning capital costs or the project’s cash flows should be analyzed before the actual start-up occurs. Furthermore, the performance of each project should be monitored throughout the project’s life. The process of formally monitoring project performance over time is called the post-audit. It involves comparing actual results with those projected by the project’s sponsors; explaining why differences occur; and analyzing potential changes to the project’s opera- tions, including replacement or termination.
The post-audit has several purposes:
• Improve forecasts. When managers systematically compare their projections to actual outcomes, estimates tend to improve. Conscious or unconscious biases can be identified and, one hopes, eliminated; new forecasting methods are sought as the need for them becomes apparent; and managers tend to do everything better, including forecasting, if they know that their actions are being monitored.
| EXHIBIT 11.9 Project Scoring Matrix
Criteria 2
Relative Score
o
Stakeholder Physicians Strongly support Support Neutral Opposed Employees Helps morale a lot Helps morale a little No effect Hurts morale Visitors Greatly enhances visit Enhances visit No effect Hurts image Social value High Moderate None Negative
Operational Outcomes Greatly improves Improves No effect Hurts outcomes Length of stay Documented decrease Anecdotal decrease No effect Increases Technology Breakthrough Improves current Adds to current Lowers Productivity Large decrease in FTEs Decrease in FTEs No change in FTEs Adds FTEs Financial Life cycle Innovation Growth Stabilization Decline Payback Less than 2 years 2-4 years 4-6 years Over 6 years IRR Over 20% 15-20% 10-15% Less than 10% Correlation Negative Uncorrelated Somewhat positive Highly positive Stakeholder factors score
Operational factors score
Financial factors score
Total score
C hapter 11: C
apital B udgeting
VI o
5io Understanding Healthcare Finance Management
Develop historical risk data. Post-audits permit managers to dev I historical data on new project analyses regarding risk and expected of return. As we discuss in Chapter 12, these data can be used to may judgments about the relative risk of future projects. Improve operations. Businesses are run by managers, and they can perform at higher or lower levels of efficiency. When a forecast is mad by the surgery department, for example, the department director and medical staff are, in a sense, putting their reputations on the line. If costs are above predicted levels and utilization is below expectations the people involved will strive, within ethical bounds, to improve the situation and bring results into line with forecasts. As one hospital CEO put it, “You academics worry only about making good decisions In the health services industry, we also have to worry about making decisions good.” Reduce losses. Post-audits monitor the performance of projects over time, so the first indication that termination or replacement should be considered often arises when the post-audit indicates that a project is performing poorly.
SELF-TEST QUESTIONS 1. Wdiat is a post-audit?
2. Why are post-audits important to the efficiency of a business?
Using Capital BudgetingTechniques in Other Contexts
The techniques developed in this chapter can help healthcare managers make a number of different types of decisions in addition to project selection. One example is the use of NPV and IRRto evaluate corporate merger opportuni- ties. Healthcare businesses often acquire other firms to increase capacity, to expand into other service areas, or for other reasons. A key element of any merger analysis is the valuation of the target firm. Although the cash flows in such an analysis typically are structured differently from those in project analysis, the same evaluation tools are applied. We demonstrate the use of these techniques in the business valuation section of Chapter 16.
Managers also use capital budgeting techniques when deciding whether to divest assets or reduce staffing. Like capital budgeting, these actions require an analysis of the impact of the decision on the business’s cash flows. When cutting personnel, businesses typically spend money up front in severance payments but then receive benefits in the form of lower labor costs in the future. When assets are sold, the pattern of cash flows is reversed—that is, cash inflows occur when the asset is sold, but any future cash inflows
Chapter 11: Capital Budgeting 511
^ociated with the asset are sacrificed. (If future cash flows are negative, the decision-—at least from a financial perspective—should be easy.) In both situ- ations, the techniques discussed here, perhaps with modification, can be applied to assess the financial consequences of the action.
1. Can capital budgeting tools be used in different settings? Explain your answer.
SELF-TEST QUESTION
Chapter Key Concepts This chapter discusses the basic capital budgeting process. Here are its key concepts:
• Capital budgeting is the process of analyzing potential expenditures on fixed assets and deciding whether the firm should undertake those investments.
• The capital budgeting process requires the firm to (1) estimate the project’s expected cash flows, (2) assess the riskiness of those flows, (3) determine the appropriate cost of capital at which to discount those flows, and (4) determine the project’s profitability and breakeven characteristics.
• The most important, but also the most difficult, step in analyzing a project is estimating the incremental cash flows that the project will generate.
• In determining incremental cash flows, opportunity costs (the cash flows forgone by using an asset) must be considered, but sunk costs (cash oudays that cannot be recouped) are not included. Further, any impact of the project on the firm’s other cash flows must be included in the analysis.
• Tax laws generally affect investor-owned firms in three ways: (1) taxes reduce a project’s operating cash flows, (2) tax laws prescribe the depreciation expense that can be taken in any year, and (3) taxes affect a project’s salvage value cash flow.
• Capital projects often require an investment in net working capital in addition to the investment in fixed assets. Such increases represent a cash outlay that, if material, must be included in the analysis. This investment is recovered when the project is terminated.
(continued)
512 Understanding Healthcare Finance Management
(continued from previous page) • Cash flow estimation bias can result if managers are overly
optimistic in their forecasts. Estimation bias should be identified and dealt with in the decision process.
• A project may have some strategic value that is not accounted for in the estimated cash flows. At a minimum, strategic value should be noted and considered qualitatively in the analysis.
• The effects of inflation must be considered in project analyses. The best procedure is to build inflation effects directly into the component cash flow estimates.
• Breakeven analysis provides decision makers with insights concerning a project’s profitability, liquidity, and risk. Time breakeven is measured by the payback period.
• Net present value (NPV), which is simply the sum of the present values of all the project’s net cash flows when discounted at the project cost of capital, measures a project’s dollar profitability. An NPV greater than $0 indicates that the project is profitable after all costs—including the opportunity cost of capital—have been considered. Further, a higher NPV indicates a more profitable project.
• Internal rate of return (IRR), which is the discount rate that forces a project’s NPV to equal zero, measures a project’s percentage rate-of-return profitability. If a project’s IRR is greater than its cost of capital, the project is profitable, and the higher the IRR, the more profitable the project.
• The NPV and IRR profitability measures provide identical indications of profitability—that is, a project that is judged to be profitable by its NPV will also be profitable by its IRR. However, when mutually exclusive projects are being evaluated, NPV might rank a different project higher than IRR. This difference can occur because the two measures have different reinvestment rate assumptions—IRR assumes that cash flows can be reinvested at the project’s IRR, while NPV assumes that cash flows can be reinvested at the project’s cost of capital.
• The modified internal rate of return (MIRR), which forces a project’s cash flows to be reinvested at the project’s cost of capital, is a better measure of a project’s percentage rate of return than the IRR is.
• If mutually exclusive projects have unequal lives, the analysis may need to be adjusted to place the projects on an equal life basis.
r Chapter 11: Capital Budgeting 513 This adjustment can be made using either the replacement chain method or the equivalent annual annuity (EAZU method.
• A project’s profitability may be enhanced if it can be abandoned before the end of its physical life.
e The net present social value (NPSV) model formalizes the capital budgeting decision process for not-for-profit firms.
• Firms often use project scoring to subjectively incorporate a large number of factors, including financial and nonfinancial factors, into the capital budgeting decision process.
• The post-audit is a key element in capital budgeting. By comparing actual results to predicted results, decision makers can improve both their operations and their cash flow estimation process.
• Capital budgeting techniques are used in a wide variety of settings in addition to project evaluation.
This concludes our discussion of the basics of capital budgeting. In the next chapter, we discuss risk assessment and incorporation—key issues in capital budgeting analysis.
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
• A chapter model that shows how to perform many of the calculations described in the chapter
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and tests your
ability to perform the calculations in preparation for a case
These resources can be accessed on the book’s companion website at ache.org/books/UHFM7.
Selected Case
Because chapters 11 and 12 contain related material, most of the applicable tases require material from both chapters and hence are listed at the end of Ac next chapter. However, one case in Cases in Healthcare Finance, 5th edi- tion, is applicable solely to this chapter:
514 Understanding Healthcare Finance Management
• Case 6: Tulsa Memorial Hospital, which focuses on estimating the breakeven volume of a walk-in clinic.
Selected Bibliography
Casolari, C., and S. Womack. 2010. “Prioritizing Capital Projects When Cash lj Scarce.” Healthcare Financial Management 64 (3): 114, 116.
Dufresne, R. 2007. “Money Well Spent: A Six-Step Approach to Effective Capital Budgeting.” Health Facilities Management 20 (5): 33-37.
Evanoo, J., and D. Cameron. 2010. “The Case to Replace: Developing a Sound Capital Equipment Strategy.” Healthcare Financial Management 64 (2)- 84-88, 90.
Grauman, D. M., G. Neff, and M. M. Johnson. 2011. “Capital Planning for Clinical Integration.” Healthcare Financial Management 65 (4): 57-66.
Harris, J. M. 2007. “Financial Planning for Major Initiatives: A Framework for Suc- cess.” Healthcare Financial Management 61 (11): 72-76, 78, 80.
Healthcare Financial Management Association. 2013. “Hospital Trends for Accessini> and Unlocking Capital.” Healthcare Financial Management 67 (11): 1-4.
Levy, A., J. Lawrence, and D. Shiple. 2009. “A Fresh Look at Capital Investments." Healthcare Financial Management 63 (3): 45-51.
Reiter, K. L., J. R. C. Wheeler, and D. G. Smith. 2008. “Liquidity Constraints on Hospital Investment When Credit Markets Arc Tight.” Journal of Health Care Finance (35) 1: 24—33.
Skorup, T. E. 2008. “Evaluating New Products and Technology: Getting the Most Value for Your Organization.” Healthcare Financial Management 62 (12): 96-99, 101-02.
Wong-Hammond, L., and L. Damon. 2013. “Financing Strategic Plans for Not-for- Profits.” Healthcare Financial Management 67 (7): 70-76.
Selected Website
• The TeachMeFinance website has several tutorial-type discussions that cover various aspects of financial management. For a capital budgeting tutorial, go to www.teachmefinance.com and click on Capital Budgeting in the list along the left side of the page.
Chapter 11: Capital Budgeting 515
Notes 1 For a discussion of the cash flow estimation practices of some large
firms, as well as some estimates of the inaccuracies involved, see Pohlman, R. A., E. S. Santiago, and F. L. Market 1988. “Cash Flow Estimation Practices of Large Firms.” Financial Management (Summer): 71-79.
2. For more on cash flow estimation bias, see Pruitt, S. W., and L. J. Gitman. 1987. “Capital Budgeting Forecast Biases: Evidence from the Fortune 500.” Financial Management (Spring): 46-51.
3. If Ann Arbor did not have taxable income to offset in Year 2 and had no taxable income to offset in previous years, the loss would have to be carried forward and hence the tax benefit would not be immediately realized. In this situation, the tax shield value of the loss would be reduced because it would be pushed into the future rather than recognized immediately. Note that IRS regulations pertaining to the carryback of losses change often to reflect changing economic conditions. At this time (2014), businesses can elect to carry back losses three, four, or five years.
4. The NPV is the same as the cumulative discounted cash flow shown for Year 5 in Exhibit 11.6. In essence, NPV can be thought of as the total cumulative discounted cash flow of the project.
5. One can argue that not-for-profit businesses do not have unlimited access to capital, and thus such firms cannot replace project cash flows with external capital. Furthermore, not-for-profit businesses usually do not have sufficient capital to accept all projects that have positive NPVs, so the return on a not-for-profit firm’s marginal project may not equal the firm’s cost of capital. Nevertheless, for not-for-profit businesses, the average aggregate return on projects will usually be close to the firm’s cost of capital, so the cost of capital is still a better reinvestment rate than the project’s IRR, especially when projects with exceptionally high or low IRRs are being evaluated. 6. For a more complete discussion of projects with non-normal cash
flows, see Brigham, E. F., and M. C. Ehrhardt. 2013. “Chapter 11.” In Financial Management: Theory and Practice. Mason, OH: South- Western Cengage Learning.
7. This section is drawn primarily from an article by Wheeler, J. R. C., and J. P. Clement. 1990. “Capital Expenditure Decisions and the Role of the Not-for-Profit Hospital: An Application of the Social Goods Model.” Medical Care Review (Winter): 467-86.
516 Understanding Healthcare Finance Management
Integrative Application
The Problem
The Scampini Clinic recently purchased a new ultrasound machine. The machine cost $22,500, and it is expected to generate net after-tax operating cash flows (including depreciation) of $6,250 per year, starting in Year 1. The machine has a five-year expected life, and the clinic’s cost of capital is 10 percent. The expected salvage values of the machine at the end of each year are given below:Year Salvage Value
0 $22,500 1 $ 17.500 2 $ 14,000 3 $ 11,000
4 $ 5,000 5 $ 0
The clinic must decide whether to operate the machine until the end of its five-year physical life or earlier.
The Analysis
The operating cash flows and salvage value for each year of the expected life of the ultrasound machine are as follows:
Year Operating Cash Flow Salvage Value
0 ($22,500) $22,500
1 $ 6,250 $ 17.500 2 $ 6,250 $ 14,000 3 $ 6,250 $ 11,000 4 $ 6,250 $ 5,000 5 $ 6,250 $ 0
Chapter 11: Capital Budgeting 517
If the clinic operates the machine for one year only, the NPV of the invest- ment at a cost of capital of 10 percent would be as follows:
NPV = -$22,500 ♦ ^5° ^17,500) _$9O9 1.10 = -$22,500 + NPV (10%, $6,250 + $17,500) = -$909
If the clinic operates the machine for two to five years, the NPV of the investment at a cost of capital of 10 percent would be as follows:
At 2 years: = -$22,500 + NPV (10%, $6,250, $6,250 + $14,000) = -$83
At 3 years: = -$22,500 + NPV (10%, $6,250, $6,250, $6,250 + $11,000) =
$1,307
At 4 years: = -$22,500 + NPV (10%, $6,250, $6,250, $6,250, $6,250 + $5,000)
=
$727
At 5 years: = -$22,500 + NPV (10%, $6,250, $6,250, $6,250, $6,250, $6,250 + $0) = $1,192
The Decision
The clinic decided to operate the ultrasound machine for three years, which is when the NPV is maximized at $1,307. Positive salvage values can only raise the expected NPV and/or IRR of a project. However, negative salvage values (removal and disposal costs, for example) could lower NPV and IRR. ■
CHAPTER
PROJECT RISK ANALYSIS 12 Learning Objectives After studying this chapter, readers should be able to
• describe the three types of risk relevant to capital budgeting decisions,
• discuss the techniques used in project risk assessment, • conduct a project risk assessment, • discuss several types of real options and their impact on a project’s
value, and • explain how risk is incorporated into the capital budgeting process.
Introduction
Chapter 11 covers the basics of capital budgeting, including cash flow estima- tion, breakeven analysis, and profitability measures. This chapter extends the discussion of capital budgeting to include risk analysis, which is composed of three elements: (1) defining the type of risk relevant to the project, (2) measuring the project’s risk, and (3) incorporating that risk assessment into the capital budgeting decision process. Although risk analysis is a key element in all financial decisions, the importance of capital investment decisions to a healthcare organization’s success makes risk analysis vital.
The higher the risk associated with an investment, the higher its required rate of return. This principle is just as valid for healthcare businesses that make capital expenditure decisions as it is for individuals who make personal investment decisions. Thus, the ultimate goal in project risk analysis is to ensure that the cost of capital used as the discount rate in a project’s profitability analysis properly reflects the riskiness of that project. The corpo- rate cost of capital, which is covered in detail in Chapter 9, reflects the cost of capital to the organization on the basis of its aggregate risk—that is, the riskiness of the business’s average project.
In project risk analysis, a project’s risk is assessed relative to the firm’s average project: Does the project have average risk, below-average risk, or above-average risk? The corporate cost of capital is then adjusted to reflect any differential risk, resulting in a project cost of capital. In general, high-risk projects are assigned a project cost of capital that is higher than the corporate
519
cost of capital, average risk projects are evaluated at the corporate cost of capital, and low-risk projects are assigned a discount rate that is less than the corporate cost of capital. (Note that when capital budgeting is conducted at the divisional level, the adjustment process is handled in a similar manner but the starting value is the divisional cost of capital.)
Types of Project Risk
Three types of project risk can be defined and, at least in theory, measured:
1. Stand-alone risk, which views the risk of a project as if it were held in isolation and hence ignores portfolio effects within the firm and among equity investors
2. Corporate risk, which views the risk of a project within the context of the business’s portfolio of projects
3. Market risk, which views a project’s risk from the perspective of the business’s owners, who are assumed to hold a well-diversified portfolio of stocks1
The type of risk that is most relevant to a particular capital budgeting decision depends on the business’s ownership and the number of projects the business operates.
Stand-Alone Risk Stand-alone risk is present in a project whenever there is a chance of a return that is less than the expected return. A project is risky whenever its cash flows are not known with certainty because uncertain cash flows mean uncertain profitability. Furthermore, the greater the probability of a return far below the expected return, the greater the risk. Stand-alone risk can be measured by the standard deviation of the project’s profitability (return on investment [ROI]), as measured typically by net present value (NPV) or internal rate of return (IRR). Because standard deviation measures the dispersion of a distri- bution about its expected value, the larger the standard deviation, the greater the probability that the project’s profitability (NPV or IRR) will be far below that expected. An alternative measure of stand-alone risk is the project’s coef- ficient of variation, which is the standard deviation divided by the project s expected NPV. Conceptually, stand-alone risk is relevant in only one situa- tion: when a not-for-profit firm is evaluating its first project. In this situation, the project will be operated in isolation, so no portfolio diversification is pres- ent; that is, the business does not have a collection of different projects, nor does it have stockholders who hold diversified portfolios of stocks.
Chapter 12: Project Risk Analysis 521
Corporate Risk ln reality, businesses usually offer many different products or services and thus can be thought of as having a large number (perhaps even hundreds) of individual projects. For example, MinuteMan Healthcare, a New England HMO (health maintenance organization), offers healthcare services to a large number of diverse employee groups in numerous service areas, and each different group can be considered a separate project. In this situation, the stand-alone risk of a project (service line) under consideration by MinuteMan is not relevant because the project will not be held in isolation. The relevant risk of a new project to MinuteMan is its contribution to the HMO’s overall risk—the impact of the project on the variability of the overall profitability of the business. This type of risk, which is relevant when the project is part of a not-for-profit business’s portfolio of projects, is called corporate risk.
A project’s corporate risk, which is measured by its corporate beta, depends on the context (i.e., the firm’s other projects), so a project may have high corporate risk to one business but low corporate risk to another, particularly when the two businesses operate in widely different industries.
Market Risk Market risk is generally viewed as the relevant risk for projects being evaluated by investor-owned businesses. The goal of shareholder (owner) wealth maxi- mization implies that a project’s returns as well as its risk should be defined and measured from the owners’ perspective. The riskiness of an individual project to a well-diversified owner is not the risk the project would have if it were owned and operated in isolation (i.e., stand-alone risk), nor is it the con- tribution of the project to the riskiness of the business (i.e., corporate risk). Most business owners hold a large diversified portfolio of stocks of many firms, which can be thought of as a large diversified portfolio of individual projects. Thus, the risk of any single project to a for-profit business’s owners is its contribution to the riskiness of their well-diversified stock portfolios.
A project’s absolute market risk, as measured by its market beta, is independent of the context; that is, a project’s market beta does not depend on the characteristics of the business, assuming the project’s cash flows are the same to all firms. However, the market risk of a project, relative to the market risk of the firm’s other projects, depends on the aggregate market risk of the firm.
1. What are the three types of project risk? 2. How is each type of project risk measured, both in absolute and
relative terms?
SELF-TEST QUESTIONS
522 Understanding Healthcare Finance Management
Relationships Among Stand-Alone, Corporate, and Market Risks
After discussing the three types of project risk and the situations in which each is relevant, it is tempting to say that stand-alone risk is almost never important because not-for-profit businesses should focus on a project’s cor- porate risk and investor-owned businesses should focus on a project’s market risk. Unfortunately, the situation is not that simple. First, it is almost impos- sible in practice to quantify a project’s corporate or market risk because it is extremely difficult—some practitioners would say impossible—to estimate the prospective return distributions for given economic states for either the project, the firm as a whole, or the market. If these return distributions cannot be estimated, the appropriate beta cannot be estimated and hence a project’s corporate or market risk cannot be quantified.
Fortunately, as will be demonstrated in the next section, it is possible to get a rough idea of the relative stand-alone risk of a project. Thus, manag- ers can make statements such as “Project A has above-average risk, Project B has below-average risk, and Project C has average risk,” all in the stand-alone sense. After a project’s stand-alone risk has been assessed, the primary factor in converting stand-alone risk to corporate or market risk is correlation. If a project’s returns are expected to be highly positively correlated with the firm’s returns, high stand-alone risk translates to high corporate risk. Simi- larly, if the firm’s returns are expected to be highly correlated with the stock market’s returns, high corporate risk translates to high market risk. The same relationships hold when the project is judged to have average or low stand- alone risk.
Most projects will be in a firm’s primary line of business and hence will be in the same line of business as the firm’s average project. Because all projects in the same line of business are generally affected by the same eco- nomic factors, such projects’ returns are usually highly correlated. When this situation exists, a project’s stand-alone risk is a good proxy for its corporate- risk. Furthermore, most projects’ returns are also positively correlated with the returns on other assets in the economy; that is, most assets have high returns when the economy is strong and low returns when the economy is weak. When this situation holds, a project’s stand-alone risk is a good proxy for its market risk.
Thus, for most projects, the stand-alone risk assessment also provides good insights into a project’s corporate and market risk. The only exception is a situation in which a project’s returns are expected to be independent of, or negatively correlated to, the business as a whole. In these situations, considerable judgment is required because the stand-alone risk assessment will over-state the project’s corporate risk. Similarly, if a project’s returns
Chapter 12: Project Risk Analysis 523
are expected to be independent of or negatively correlated to the market’s returns, the project’s stand-alone risk will overstate its market risk.
An additional problem arises with investor-owned healthcare busi- nesses. Finance theory specifies that investor-owned businesses should focus on market risk when making capital budgeting decisions. However, most healthcare businesses (even proprietary ones) have corporate goals that focus on the provision of quality healthcare services in addition to owner (share- holder) wealth maximization. Furthermore, a proprietary healthcare busi- ness’s stability and financial condition, which primarily depend on corporate risk, are important to all the firm’s other stakeholders: its managers, physi- cians, patients, community, and so on. Some financial theorists even argue that stockholders, including those that are well diversified, consider factors other than market risk when setting required returns. This point is especially meaningful for small businesses because their owners/managers are not well diversified in their relationship to the business. Considering all the factors, it may be reasonable for managers of investor-owned healthcare businesses, particularly small ones, to be just as concerned about corporate risk as are managers of not-for-profit businesses. Fortunately, in most real-world situa- tions, a project’s risk in the corporate sense will be the same as its risk in the market sense.2
1. Name and define the three types of risk relevant to capital budgeting.
2. How are these risks related? 3. Should managers of investor-owned providers focus exclusively on
a project’s market risk?
SELF-TEST QUESTIONS
Risk Analysis Illustration
To illustrate project risk analysis, consider Ridgeland Community Hospital’s evaluation of a new MRI (magnetic resonance imaging) system presented in Chapter 11. Exhibit 12.1 contains the project’s cash flow analysis. If all of the project’s component cash flows were known with certainty, the project’s projected profitability would be known with certainty and hence the project would have no risk. However, in most project analyses, future cash flows— and hence profitability—are uncertain and, in many cases, highly uncertain, so risk is present.
The component cash flow distributions and their correlations with one another determine the project’s profitability distribution and hence the proj- ect’s risk. In the following sections, three quantitative techniques for assessing
On the web at: ache.org/books/ UHFM7
EXHIBIT 12.1 Ridgeland Community Hospital: MRI Site Cash Flow Analysis
<Z1
Annual Cash Flows
0 1 2 3 4 5
1. System cost ($1,500,000) 2. Related expenses (1,000,000)
3. Gross revenues $1,000,000 $1,050,000 $1,102,500 $1,157,625 $ 1,215,506 4. Deductions 250,000 262,500 275,625 289,406 303,876 5. Net revenues $ 750,000 $ 787,500 $ 826,875 $ 868,219 $ 911,630
6. Labor costs 50,000 52,500 55,125 57,881 60,775
7. Maintenance costs 150,000 157,500 165,375 173,644 182,326
8. Supplies 30,000 31,500 33,075 34,729 36,465
9. Incremental overhead 10,000 10,500 11,025 H,576 12,155
10. Depreciation 350,000 350,000 350,000 350,000 350,000 11. Operating cash flow $ 160,000 $ 185,500 $ 212,275 $ 240,389 $ 269,908
12. Taxes 0 0 0 0 0
13. Net operating cash flow $ 160,000 $ 185,500 $ 212,275 $ 240,389 $ 269,908
14. Depreciation 350,000 350,000 350,000 350,000 350,000
15. Net salvage value 750,000 16. Net cash flow ($2,500,000) $ 510,000 $ 535,500 $ 562,275 $ 590,389 $1,369,908
Profitability measures: Net present value (NPV) = $82,493. Internal rate of return (IRR) = 11.1%.
U nderstanding H
ealthcare Finance M anagem
ent
r Chapter 12: Project Risk Analysis 525a project’s risk are discussed: (1) sensitivity analysis, (2) scenario analysis, and (3) Monte Carlo simulation. In a later section, we present a qualitative approach to risk assessment.
1. What condition creates project risk? 2. What makes one project riskier than another? 3. What type of risk is initially assessed?
SELF-TEST QUESTIONS
Sensitivity Analysis
Historically, sensitivity analysis has been classified as a risk assessment tool. In reality, it is not very useful in assessing a project’s risk. However, it does have significant value in project analysis, so we discuss it in some detail here.
Many of the variables that determine a project’s cash flows are subject to some type of probability distribution rather than known with certainty. If the realized value of such a variable is different from its expected value, the project’s profitability will differ from its expected value. Sensitivity analysis indicates exactly how much a project’s profitability—NPV, IRR, or modified internal rate of return (MIRR)—will change in response to a given change in a single input variable, with all other input variables held constant.
Sensitivity analysis begins with the base case developed using expected values (in the statistical sense) for all uncertain variables. For example, assume that Ridgeland’s managers believe that all of the MRI project’s component cash flows—except for weekly volume and salvage value—are known with relative certainty. The expected values for these variables (volume = 40 and salvage value = $750,000) were used in Exhibit 12.1 to obtain the base case NPV of $82,493. Sensitivity analysis is designed to provide managers with the answers to such questions as, What if volume turns out to be more or less than the expected level? What if salvage value turns out to be more or less than expected? (Typically, more than two variables would be examined in a sensitivity analysis. We use only two to keep the illustration manageable.)
In a sensitivity analysis, each uncertain input variable typically is changed by a fixed percentage amount above and below its expected value while all other variables are held constant at their expected values. Thus, all input variables except one are held at their base case values. The resulting NPVs (or IRRs or MIRRs) are recorded and plotted. Exhibit 12.2 contains the NPV sensitivity analysis for the MRI project, assuming that there are two uncertain variables: (1) volume and (2) salvage value.
Note that the NPV is a constant $82,493 when there is no change tn either of the uncertain variables because a 0 percent change recreates the base case. The values in Exhibit 12.2 give managers a feel for which input
On the web at: ache.org/books/ UHFM7
526 Understanding Healthcare Finance Management
EXHIBIT 12.2 MRI Project
Sensitivity Analysis
Net Present Value
Change from Base Case Level Volume
Salvage Value
-30% ($814,053) ($ 57,215) -20 (515.193) (10,646) -10 (216,350) 35,923
0 82,493 82,493 +10 381,335 129,062 +20 680,178 175,631 +30 979,020 222,200
variable will have the greatest impact on the MRI project’s profitability—the larger the NPV change for a given percentage input change, the greater the impact. Considering only these two variables, we see that the MRI project’s NPV is affected by changes in volume to a much greater degree than it is by changes in salvage value.
Often, the results of sensitivity analyses are shown in graphical form. For example, the Exhibit 12.2 sensitivity analysis is graphed in Exhibit 12.3. Here, the slopes of the lines show how sensitive the MRI project’s NPV is to changes in each of the uncertain input variables—the steeper the slope, the more sensitive NPV is to a change in the variable. Note that the sensitivity lines intersect at the base case values—0 percent change from base case level and $82,493. Also, spreadsheet models are ideally suited for performing sen- sitivity analyses because such models automatically recalculate NPV when an input value is changed and facilitate graphing.3
Exhibit 12.3 illustrates that the MRI project’s NPV is very sensitive to volume and only mildly sensitive to changes in salvage value. A sensitiv- ity plot that has a negative slope indicates that increases in the value of that variable decrease the project’s NPV. If two projects were being compared, the one with the steeper sensitivity lines would be regarded as riskier because a relatively small error in estimating a variable—for example, volume—would produce a large difference in the project’s realized NPV. Thus, a realized volume less than that expected means that the project’s actual NPV will be far less than that expected. If information were available on the sensitivity of NPV to input changes to Ridgeland’s average project, similar judgments regarding the riskiness of the MRI project could be made, but they would be relative to the firm’s average project.
Although sensitivity analysis historically has been thought of as a risk assessment tool, it has severe limitations in this role. For example, suppose that Ridgeland had a contract with an HMO that guaranteed a minimum
Chapter 12: Project Risk Analysis 527
Net Present Value (thousands of dollars)
EXHIBIT 12.3 Sensitivity Analysis Graph
800
600
400
200
0
-200
-400
-600
-800
Salvage Value
1 -30 -20 -10 0 10 20 30
Percentage Change from Base Case
MRI volume at a fixed reimbursement rate. In that situation, volume would not contribute to project risk at all, despite the sensitivity analysis showing NPV to be highly sensitive to changes in volume. In general, a project’s stand-alone risk depends on the sensitivity of its profitability to changes in key input variables and the ranges of likely values of these variables. Because sensitivity analysis considers only the first factor, its results can be misleading. Furthermore, sensitivity analysis does not consider interactions among the uncertain input variables; it considers each variable independently.
Despite its shortcomings in risk assessment, sensitivity analysis does provide managers with valuable information. First, it provides some break- even information about the project’s uncertain variables. For example, exhibits 12.2 and 12.3 show that just a small decrease in expected volume makes the project unprofitable, whereas the project remains profitable even if salvage value falls by more than 10 percent. Although somewhat rough, this breakeven information is clearly valuable to Ridgeland’s managers. (The breakeven points can be easily refined by using Excel’s Goal Seek capability.) Second, and perhaps more important, sensitivity analysis helps manag- ers identify which input variables are most critical to the project’s profitability and hence to the project’s financial success. In this MRI example, volume is clearly the key input variable of the two that were examined, so Ridgeland’s managers should ensure that the volume estimate is the best possible. The concept here is that Ridgeland’s managers have a limited amount of time to
1 zz__
528 Understanding Healthcare Finance Management
spend on analyzing the MRI project, and sensitivity analysis enables the focus on what’s most important. m to
The ability to identify the critical input variables also is useful audit. If the project is performing poorly and changes must be made such changes will have the greatest positive impact if they are made to one of critical variables. In our illustration, if the MRI project is initiated but ' profitability is not meeting forecasts, it clearly is better to focus on increasin volume than on increasing the salvage value.
SELF-TEST QUESTIONS
On the web at: ache.org/books/
UHFM7
1. Briefly describe sensitivity analysis. 2. What type of risk does it attempt to measure? 3. Is sensitivity analysis a good risk assessment tool? If not, what is its
value in the capital budgeting process?
Scenario Analysis
Scenario analysis is a stand-alone risk analysis technique that considers (1) the sensitivity of NPV or another profitability measure to changes in key vari- ables, (2) the likely range of variable values, and (3) the interactions among the variables. To conduct a scenario analysis, managers pick a “bad” set of cir- cumstances (e.g., low volume, low salvage value), an average or “most likely” set, and a “good” set (e.g., high volume, high salvage value). The resulting input values are then used to create a probability distribution of NPV.
For an illustration of scenario analysis, assume that Ridgeland’s man- agers regard a drop in weekly volume below 30 scans as very unlikely, and a volume above 50 is also improbable. On the other hand, salvage value can be as low as $500,000 or as high as $1 million. The most likely values are 40 scans per week for volume and $750,000 for salvage value. Thus, a volume of 30 and a $500,000 salvage value define the lower bound (or worst case scenario), while a volume of 50 and a salvage value of $1 million define the upper bound (or best case scenario).
Ridgeland can now use the worst, most likely, and best case values for the input variables to obtain the NPV corresponding to each scenario. Ridgeland’s managers used a spreadsheet model to conduct the analysis, and Exhibit 12.4 summarizes the results. The most likely case results in a positive NPV, the worst case produces a large negative NPV, and the best case results in an even larger positive NPV. These results, along with each scenario’s probability of occurrence, can now be used to determine the expected NPV and standard deviation of NPV. Suppose that Ridgeland’s managers estimate that there is a 20 percent chance that the worst case will occur, a 60 percent chance that the most likely case will occur, and a 20 percent chance that the
Chapter 12: Project Risk Analysis 529
Scenario
Probability of Outcome Volume Salvage Value NPV
Worst case Most likely case Best case
0.20 0.60 0.20
30 40 50
$ 500,000 750,000
1,000,000
($ 819,844) 82,493
984,829
EXHIBIT 12.4 MRI Project Scenario Analysis
Expected value Standard deviation
40 $ 750,000 $ 82,493 $ 570,688
best case will occur. Of course, it is difficult to estimate scenario probabilities with any confidence, and, in most situations, the probabilities used will not be symmetric. For example, in an environment of increasing managed care penetration and increasing competition among providers, the probability may be higher for the worst case scenario than for the best case scenario. Exhibit 12.4 contains a discrete distribution of returns, so the expected NPV can be found as follows:
Expected NPV = (0.20 x [-$819,844]) + (0.60 x $82,493)
+ (0.20 x $984,829)
= $82,493.
The expected NPV in the scenario analysis is the same as the base case NPV—$82,493. The results are consistent because the values of the uncer- tain variables used in the scenario analysis—30, 40, and 50 scans for volume and $500,000, $750,000, and $1 million for salvage value—when coupled with the scenario probabilities produce the same expected values that were used in the Exhibit 12.1 base case analysis. If inconsistencies exist between the base case NPV and the expected NPV in the scenario analysis, the two analyses have inconsistent input assumptions. In general, such inconsisten- cies should be identified and removed to ensure that common assumptions are used throughout the project risk analysis. However, remember that our purpose here is to conduct a risk assessment, not to measure profitability. Ultimately, we will use the base case (expected value) cash flows to reassess the project’s profitability when we have completed the risk assessment. The standard deviation of NPV, as shown here, is $570,688:
oNpv = [0.20 x (-$819,844 - $82,493)2 + 0.60 x ($82,493 - $82,493)2
+ 0.20 x ($984,829 - $82,493)2]’/2
= $570,688,
530 Understanding Healthcare Finance Management
while the coefficient of variation (CV) of NPV is 6.9:
Qy gNPv $570,688 Expected NPV $82,493
The MRI project’s standard deviation and coefficient of variati measure its stand-alone risk. Suppose that when a similar scenario analys' is applied to Ridgeland’s aggregate cash flows (average project) the result' a coefficient of variation of NPV in the range of 2.5 to 5.0. Then, on the basis of its stand-alone risk measured by coefficient of variation, along with subjective judgments, Ridgeland’s managers might conclude that the MRl project is riskier than the firm’s average project, so it would be classified as a high-risk project.
Scenario analysis can also be interpreted in a less mathematical way The worst-case NPV—a loss of about $800,000—is an estimate of the worst possible financial consequences of the MRI project. If Ridgeland can absorb such a loss in value without much impact on its financial condition, the proj- ect does not pose significant financial danger to the hospital. Conversely, if such a loss would mean financial ruin for the hospital, its managers might be unwilling to undertake the project, regardless of its profitability under the most likely and best case scenarios. Note that the risk of the project is not changing in these two situations. The difference is in the organization’s abil- ity to bear the risk inherent in the project.
While scenario analysis provides useful information about a project’s stand-alone risk, it is limited in two ways. First, it considers only a few discrete states of the economy and hence provides information on only a few potential profitability outcomes for the project. In reality, an almost infinite number of possibilities exist. Although the illustrative scenario analysis contained only three scenarios, it can be expanded to include more states of the economy— say, five or seven. However, there is a practical limit on how many scenarios can be included in a scenario analysis.
Second, scenario analysis—at least as normally conducted—implies a definite relationship among the uncertain variables involved. For example, our analysis assumed that the worst value for volume (30 scans per week) would occur at the same time as the worst value for salvage value ($500,000) because the worst case scenario is defined by combining the worst possible value of each uncertain variable. Although this relationship (all worst values occurring together) may hold in some situations, it may not hold in others. If volume is low, for example, maybe the MRI will withstand less wear and tear and hence be worth more after five years of use. The worst value for volume, then, should be coupled with the best salvage value. Conversely, poor volume may be symptomatic of poor medical effectiveness of the MRI and hence lead to
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ted demand for used equipment and a low salvage value. Scenario analysis •nds to create extreme profitability values for the worst and best cases because automatically combines all worst and best input values, even if these values have only a remote chance of occurring together. This problem can be miti- tcd but not eliminated, by assigning relatively low probabilities to the best and worst cases. The next section describes a method of assessing a project’s stand-alone risk that deals with these two problems.
1. Briefly describe scenario analysis. 2. What type of risk does it attempt to measure? 3. What are its strengths and weaknesses?
SELF-TEST QUESTIONS
Monte Carlo Simulation
Monte Carlo simulation, so named because it developed out of work on the mathematics of casino gambling, describes uncertainty in terms of continu- ous probability distributions, which have an infinite number of outcomes rather than just a few discrete values. Thus, Monte Carlo simulation provides a more realistic view of a project’s risk than does scenario analysis.
Although the use of Monte Carlo simulation in capital investment decisions was first proposed many years ago, it was not used extensively in practice primarily because it required a mainframe computer along with relatively powerful financial planning or statistical software. Now, however, Monte Carlo simulation software can be installed on personal computers as an add-on to a spreadsheet program. Because most financial analysis today is done with spreadsheets, Monte Carlo simulation is now accessible to virtually all health services organizations, both large and small.
The first step in a Monte Carlo simulation is to create a model that calculates the project’s net cash flows and profitability measures, just as was done for Ridgeland’s MRI project. The relatively certain variables are esti- mated as single, or point, values in the model, while continuous probability distributions are used to specify the uncertain cash flow variables. After the model has been created, the simulation software automatically executes the following steps:
1. The Monte Carlo program chooses a single random value for each uncertain variable on the basis of its specified probability distribution.
2. The values selected for each uncertain variable, along with the point values for the relatively certain variables, are combined in the model to estimate the net cash flow for each year.
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3. Using the net cash flow data, the model calculates the project’s profitability—for example, as measured by NPV. A single complex these three steps constitutes one iteration, or run, in the Monte C simulation.
4. The Monte Carlo software repeats the above steps many times (e 5,000). Because each run is based on different input values, each rii produces a different NPV.
The ultimate result of the simulation is an NPV probability distribu tion based on a large number of individual scenarios, which encompasses almost all of the likely financial outcomes. Monte Carlo software usual]] displays the results of the simulation in both tabular and graphical fornj and automatically calculates summary statistical data such as expected value standard deviation, and skewness.4
For an illustration of Monte Carlo simulation, again consider Ridge- land’s MRJ project. As in the scenario analysis, the illustration has been sim- plified by specifying the distributions for only two key variables: (1) weekly volume and (2) salvage value. Weekly volume is not expected to vary by more than ±10 scans from its expected value of 40 scans. Because this situation is symmetrical, the normal (bell-shaped) distribution can be used to represent the uncertainty inherent in volume. In a normal distribution, the expected value ±3 standard deviations will encompass almost the entire distribution. Thus, a normal distribution with an expected value of 40 scans and a standard deviation of 10/3 = 3.33 scans is a reasonable description of tire uncertainty inherent in weekly volume.
A triangular distribution was chosen for salvage value because it specifically fixes the upper and lower bounds, whereas the tails of a normal distribution are, in theory, limitless. The triangular distribution is also used extensively when the input distribution is nonsymmetrical because it can easily accommodate skewness. Salvage value uncertainty was specified by a triangular distribution with a lower limit of $500,000, a most likely value of $750,000, and an upper limit of $1 million.
The basic MRI model containing these two continuous distributions was used, plus a Monte Carlo add-on to the spreadsheet program, to con- duct a simulation with 5,000 iterations. The output is summarized in Exhibit 12.5, and the resulting probability distribution of NPV is plotted in Exhibit 12.6. The mean, or expected, NPV ($82,498) is about the same as the base case NPV and expected NPV indicated in the scenario analysis ($82,493). In theory, all three results should be the same because the expected values for all input variables are the same in the three analyses. However, some ran- domness exists in the Monte Carlo simulation that leads to an expected NP'' that is slightly different from the others. The more iterations that are run,
Chapter 12: Project Risk Analysis 533
Expected NPV $ 82,498 Minimum NPV ($951,760) Maximum NPV $970,191 Probability of a positive NPV 62.8% Standard deviation $256,212 Skewness 0.002
EXHIBIT 12.5 Simulation Results Summary
the more likely the Monte Carlo NPV will be the same as the base case NPV, assuming that the assumptions are consistent.
The standard deviation of NPV is lower in the simulation analysis because the NPV distribution in the simulation contains values within the entire range of possible outcomes, while the NPV distribution in the scenario analysis contains only the most likely value and the best case and worst case extremes. In this illustration, one value for volume uncertainty was specified for all five years; that is, the value chosen by the Monte Carlo software for volume in Year 1—for example, 40 scans—was used as the volume input for the remaining four years in that iteration of the simulation analysis. As an alternative, the normal distribution for Year 1 can be applied to each year separately, which would allow the volume forecasts to vary from year to year. Then, the Monte Carlo software might choose 35 as the value for Year 1, 43 as the Year 2 input, 32 for Year 3, and so on. This approach, however, prob- ably does not do a good job of describing real-world behavior; high usage
Probability
EXHIBIT 12.6
NPV Probability Distribution
in the first year presumably means strong acceptance of the MRI system hence high usage in the remaining years. Similarly, low usage in the first probably portends low usage in future years.
and Yea r
independent in 1 software from
The volume and salvage value variables were treated as the simulation; that is, the value chosen by the Monte Carle
the salvage value distribution was not related to the value chosen from th" volume distribution. Thus, in any run, a low volume can be coupled with high salvage value and vice versa. If Ridgeland’s managers believe that high utilization at the hospital indicates a strong national demand for MRI Sys terns, they can specify a positive correlation between these variables. A posi five correlation would tend to increase the riskiness of the project because a low volume pick in one iteration cannot be offset by a high salvage value pick. Conversely, if the salvage value is more a function of the technological advances that occur over the next five years than local utilization, it may be- hest to specify the variables as independent, as was done.
As in scenario analysis, the project’s simulation results must be com- pared with a similar analysis of the firm’s average project. If Ridgeland’s aver- age project were considered to have less stand-alone risk when a Monte Carlo simulation was conducted, the MRI project would be judged to have above average (high) stand-alone risk.
Monte Carlo simulation has two primary advantages over scenario analysis: (1) All possible input variable values are considered, and (2) correla- tions among the uncertain inputs can be incorporated into the analysis. How- ever, there is a downside to these two advantages: Although it is mechanically easy to input the probability distributions for the uncertain variables as well
as their correlations into a Monte Carlo simulation, it is much more difficult to determine what those distributions and correlations are. The problem is that the more information a risk analysis technique requires, the harder it is to develop the data with any confidence; hence, managers are left with an elegant result of questionable value.
SELF-TEST QUESTIONS 1. Briefly, what is Monte Carlo simulation?
2. What type of risk does it attempt to measure? 3. What are its strengths and weaknesses?
Qualitative Risk Assessment
In some situations, it may be difficult to conduct a quantitative risk assess- ment because the input variable estimates are nebulous. In other situations, a quantitative assessment may be possible, but a verification of results provides
Chapter 12: Project Risk Analysis 535
iaIiagers with additional confidence. More nd more healthcare organizations are
ing qualitative risk assessment techniques to confirm quantitative assessment results
or as the sole basis for the risk assessment. Qualitative risk assessment is based on the answers to a set of questions. For example, one large healthcare clinic uses these questions:
• Does the project require additional market share or represent a new service initiative?
• Is the project outside the scope of current management expertise?
• Does the project require difficult-to- recruit physicians, nurses, or technical specialists?
• Will the project pit the organization against a strong competitor?
• Does the project involve new, unproven technology?
Each “yes” answer is assigned one point (while each “no” answer receives zero points). If the total point count for the project is zero, it is judged to have low risk; one or two points indicate moderate risk, and three or more points indicate high risk. Although such a subjective approach appears to have little theoretical basis, a closer examina- tion reveals that each question in the above list is tied to cash flow uncer- tainty. The greater the number of “yes” answers, the greater the cash flow uncertainty and hence the greater the stand-alone risk of the project.
The value of using the qualitative risk assessment approach in conjunc- tion with a quantitative risk assessment is that it forces managers to think about project risk in alternative frameworks. If the quantitative and qualita- tive assessments do not agree, the project’s risk assessment requires more consideration.
After some discussion, Ridgeland’s managers concluded that the MRI project’s qualitative risk assessment score was 3. Thus, the quantitative and qualitative assessments reached the same conclusion: The project has high risk.
How Many Scenarios in a Scenario Analysis? In the scenario analysis of Ridgeland’s MRI proj- ect, we used three scenarios. However, three is no magic number, given that the more scenarios used, the more information is obtained from the analysis. Furthermore, more scenarios lessen the problem associated with extreme values because the best- and worst-case scenarios can be assigned low probabilities (which are probably realistic) without causing the risk inherent in the project to be understated.
Although more scenarios add additional real- ism and provide more information for decision makers, a greater number of scenarios increases forecasting difficulty and makes the analysis more time consuming. Furthermore, the greater the number of scenarios, the more difficult it is to interpret the results. Thus, the entire process is easier if three scenarios are used rather than, say, nine.
What do you think? Are three scenarios suf- ficient or should more be used? How many sce- narios are too many? Is it better to have an odd number than an even number of scenarios? Is there an optimal number of scenarios?
536 Understanding Healthcare Finance Management
SELF-TEST QUESTIONS 1. Describe qualitative risk assessment.
2. Why does a qualitative risk assessment work? 3. Assume a quantitative risk assessment has been conducted on a
project. Is a qualitative risk assessment necessary?
Incorporating Risk into the Decision Process
Thus far, the MRI illustration has demonstrated that a project’s riskiness is difficult to quantify. It may be possible to reach a general conclusion that one project is more or less risky than another or to compare the riskiness of a project with the business as a whole, but it is difficult to develop a good measure of project risk. This lack of precision in measuring project risk adds to the difficulties involved in incorporating differential risk into the capital budgeting decision.
There are two methods for incorporating project risk into the capi- tal budgeting decision process: (1) the certainty equivalent method, which adjusts a project’s expected cash flows to reflect project risk, and (2) the risk- adjusted discount rate method, which deals with differential risk by changing the cost of capital. Although most businesses use the risk-adjusted discount rate method, there are some theoretical advantages to using the certainty equivalent method. Furthermore, it raises some interesting issues related to the risk-adjustment process.
Certainty Equivalent Method The certainty equivalent (CE) method directly follows the economic concept of utility.3 Under the CE approach, managers must first evaluate a cash flow’s risk and then specify how much money, with certainty, would be required for an individual to be indifferent between the riskless (certain) sum and the risky cash flow’s expected value. For example, suppose that a rich eccentric offered someone the following choices:
• Flip a coin. If it’s a head, the individual receives $1 million; if it’s a tail, the individual receives nothing. The expected value of the gamble is (0.5 x $1,000,000) + (0.5 x $0) = $500,000, but the actual outcome will be either zero or $1 million, so the gamble is highly risky.
• Do not flip the coin. Simply pocket $400,000 in cash.
If the individual is indifferent to the two alternatives, $400,000 is defined to be her CE amount for this particular risky expected $500,000 cash flow. The riskless $400,000 provides that individual with the same satisfac- tion (utility) as the risky $500,000 expected return.
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In general, investors are risk averse, so the CE amount for this gamble will be something less than the $500,000 expected value. Each individual would have his own CE value—the greater the individual’s degree of risk aversion, the lower the CE amount.
The CE concept can be applied to capital budgeting decisions, at least in theory, in this way:
• Convert each net cash flow of a project to its CE value. Here, the riskiness of each cash flow is assessed, and a CE cash flow is chosen on the basis of that risk. The greater the risk, the greater the difference between the expected value and its lower CE value. (If a cash outflow is being adjusted, the CE value is higher than the expected value. The unique risk adjustments required on cash outflows will be discussed in a later section.)
• Once each cash flow is expressed as a CE, discount the project’s CE cash flow stream by the risk-free rate to obtain the project’s differential risk adjusted NPV.6 Here, the term differential risk-adjusted implies that the unique riskiness of the project, as compared to the overall riskiness of the business, has been incorporated into the decision process. The risk-free rate is used as the discount rate because CE cash flows are analogous to risk-free cash flows.
• A positive differential risk-adjusted NPV indicates that the project is profitable even after adjusting for differential (project-specific) risk.
The CE method is simple and neat. Furthermore, it can easily handle differential risk among the individual cash flows. For example, the final year’s CE cash flow might be adjusted downward an additional amount to account for salvage value risk if that risk is considered to be greater than the risk inher- ent in the operating cash flows.
Unfortunately, there is no practical way to estimate a risky cash flow’s CE value. No benchmarks are available to inform the estimate, so each indi- vidual would have her own estimate, and they can vary significantly. Also, the risk assessment techniques—for example, scenario analysis—focus on profit- ability and hence measure the stand-alone risk of a project in its entirety. This process provides no information about the riskiness of individual cash flows, so there is no basis for adjusting each cash flow to reflect its own unique risk.
Risk-Ad justed Discount Rate Method In the risk-adjusted discount rate (RADR) method, expected cash flows are used in the valuation process, and the risk adjustment is made to the discount rate (the opportunity cost of capital). All average-risk projects are discounted at the business’s corporate cost of capital, which represents the opportunity cost of capital for average-risk projects; high-risk projects are assigned a
538 Understanding Healthcare Finance Management
higher cost of capital; and low-risk projects are discounted at a lower • capital.
One advantage to using the RADR method is that it has a benchmark: the business’s corporate cost of capital. This discount rctiCi» the riskiness of the business in the aggregate, or the riskiness of the fl average project. Another advantage is that project risk-assessment technj identify a project’s aggregate risk—the combined risk of all of the flows—and the RADR applies a single adjustment to the cost of capital rathe than attempts to adjust individual cash flows. However, the disadvantage d that, typically, there is no theoretical basis for setting the size of the RADR adjustment, so the amount of adjustment remains a matter of judgment
There is one additional disadvantage to using the RADR method RADR combines the factors that account for time value (the risk-free rate) and the adjustment for risk (the risk premium): Project cost of capital = Djf. ferential risk-adjusted discount rate = Risk-free rate + Risk premium. The CE approach, on the other hand, keeps risk adjustment and time value sepa- rate—time value in the discount rate and risk adjustment in the cash flows. Bv lumping together risk and time value, the RADR method compounds the risk premium over time, just as interest compounds over time. This compound- ing of the risk premium means that the RADR method automatically assigns more risk to cash flows that occur in the distant future, and the farther into the future, the greater the implied risk. Because the CE method assigns risk to each cash flow individually, it does not impose assumptions regarding the relationship between risk and time.
The RADR model is one method used to incorporate risk in the capi- tal budgeting decision process. It is based on the following concept:
Key Equation 12.1: Risk-Adjusted Discount Rate (RADR) Theoretical Model
Project cost of capital = Risk-free rate + Risk premium.
The idea here is that the risk-free rate accounts for the time value of money, while the risk premium accounts for the unique (below average, average, or above average) risk of the project. The RADR method as it is normally used—with a constant discount rate applied to all cash flows of a project—implies that risk increases with time. This implication imposes a greater burden on long-term projects, so short-term projects tend to look better financially than do long-term projects. For most projects, the assump- tion that risk increases over time is probably reasonable because cash flows are more difficult to forecast the farther one moves into the future. How- ever, managers should be aware that the RADR approach automatically
Chapter 12: Project Risk Analysis 539
palizes distant cash flows, and an additional explicit penalty based solely f cash flow timing is not warranted unless some specific additional risk can
k identified.
1 What are the differences between the CE and RADR methods for risk incorporation?
2. What assumptions about time and risk are inherent in the RADR method?
3. How do most businesses incorporate differential risk into the capital budgeting decision process?
SELF-TEST QUESTIONS
Final Risk Assessment and Incorporation for the MRI Project
In most project risk analyses, it is impossible to quantitatively assess the project’s corpo- rate or market risk and managers are left with only an assessment of the project’s stand- done risk. However, like the MRI project, most projects being evaluated are in the same line of business as the firm’s other projects, and the profitability of most firms is highly correlated with the overall economy. Thus, stand-alone, corporate, and market risk are usually highly correlated, which suggests that managers can get a feel for the relative risk of most projects on the basis of the quantitative and qualitative analyses conducted to assess the project’s stand-alone risk. In Ridgeland’s case, its managers concluded that the MRI project, with its above-average stand-alone risk, also had above-average corporate risk, which is the risk most relevant to not-for- profit organizations; hence, the project was categorized as a high-risk project.
The business’s corporate cost of capi- tal provides a basis for estimating a project’s differential risk-adjusted discount rate— average-risk projects are discounted at the corporate cost of capital, high-risk projects are discounted at a higher cost of capital,
Uncertainty in Initial Cash Outflows In many capital budgeting situations, the initial cost of the project—especially when occurring only at Time 0—is assumed to be known with certainty. The idea here is that, in most cases, bids have already been received from vendors, so the initial cost can be predicted with relative precision. However, in some circumstances, there can be substantial uncertainty in initial costs. For example, there can be a great deal of uncertainty in the cost of a building that will not be con- structed for several years. Or there can be uncer- tainty in the cost of a major construction project that will take several years to complete.
When there is uncertainty in initial cost, how should that risk be incorporated into the analy- sis? If the entire cost (or even the major portion) occurs at Time o, the discount rate is not applied to the cash flow, so the RADR method will not get the job done.
What do you think? Can the CE method be used? Assume that Time 0 costs on a project could be $100,000 or $150,000 with equal profit- ability, so the expected initial cost is $125,000. What is your estimate of the CE cash flow? (Hint: Remember that risk adjustments to cash outflows are the opposite of those applied to inflows.)
540 Understanding Healthcare Finance Management
and low-risk projects are discounted at a rate below the corporate cost of capj tai. Unfortunately, there is no good way of specifying exactly how much higher or lower these discounts rates should be; given the present state of the art, risk adjustments are necessarily judgmental and somewhat arbitrary.
Ridgeland’s standard procedure is to add 4 percentage points to its 10 percent corporate cost of capital when evaluating high-risk projects and to subtract 2 percentage points when evaluating low-risk projects. Thus, to estimate the high-risk MRI project’s differential risk-adjusted NPV, the proj- ect’s expected (base case) cash flows shown in Exhibit 12.1 are discounted at 10% + 4% = 14%. This rate is called the project cost of capital, as opposed to the corporate cost of capital, because it reflects the risk characteristics of a specific project rather than the aggregate risk characteristics of the business The resultant NPV is -$200,017, so the project becomes unprofitable when the analysis is adjusted to reflect its high risk. Ridgeland’s managers may still decide to go ahead with the MRI project, but at least they know that its expected profitability is not sufficient to make up for its riskiness.
The RADR Model is implemented as follows:
Key Equation 12.2: Risk-Adjusted Discount Rate (RADR) Implementation Model Project cost of capital = Corporate cost of capital + Risk adjustment.
Here, the corporate cost of capital is used as the base rate (start- ing point), and a risk adjustment is applied if the project has non-average risk. For above-average risk projects, the risk premium is added to the base rate, while the risk premium is subtracted for those projects judged to have below-average risk. To illustrate, assume a project having above-average risk is being evaluated. The corporate cost of capital is 10 percent, and the stan- dard adjustment amount is 3 percentage points. With these assumptions, die project cost of capital is 13 percent:
Project cost of capital = Corporate cost of capital + Risk adjustment
= 10% + 3% = 13%.SELF-TEST QUESTIONS 1. How did Ridgeland’s managers translate the MRI project’s stand-
alone risk assessment into a corporate risk assessment? 2. How was risk incorporated into the MRI project decision process? 3. Is the risk adjustment objective or subjective? 4. What is a project cost of capital?
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incorporating Debt Capacity into the Decision Process
juSt as different businesses have different optimal capital structures, so do individual projects. In any business, the overall optimal capital structure, which is reflected by the weights used in the corporate cost of capital esti- niate, is an aggregation of the optimal capital structures of the business’s individual projects. However, some projects support only a little debt, while other projects support a high level of debt. The proportion of debt in a project’s, or a business’s, optimal capital structure is called the project’s, or business’s, debt capacity.
One mistake often made when considering a project’s debt capacity is to look at how the project is actually financed. For example, even though Ridgeland may be able to obtain a secured loan for the entire cost of the MRI equipment, the MRI project does not have a debt capacity of 100 percent. The willingness of lenders to furnish 100 percent debt capital for the MRI project is based more on Ridgeland’s overall creditworthiness than on the financial merits of the MRI project because all of the hospital’s operating cash flow, less interest payments on embedded debt, is available to pay the lender. Think of it this way: Would lenders provide 100 percent financing if Ridgeland were a start-up business and the MRI project was its sole source of income?
The logical question here is whether debt capacity differences should be taken into consideration in the capital budgeting process. In theory, if there are meaningful debt capacity differences between a project and the business, capital structure differentials—as well as risk differentials—should be taken into account in the capital budgeting process. For example, an aca- demic health center might be evaluating two projects: one involves research and development (R&D) of a new surgical procedure, and the other involves building a primary care clinic in a local upscale residential area. The R&D project would have relatively low debt capacity because it has high business risk and no assets suitable as loan collateral. Conversely, the clinic project would have relatively high debt capacity because it has low business risk and involves real estate suitable as collateral.
Incorporating capital structure differentials is mechanically easy. We merely change the weights used to compute the corporate cost of capital to reflect project debt capacity rather than use the standard weights that reflect the business’s target capital structure. Projects with higher-than-average debt capacity would use a relatively high value for the weight of debt and a rela- tively low value for the weight of equity and vice versa. However, a problem arises when attempting to make debt capacity adjustments. We know from Chapter 10 that increased debt usage raises capital costs, so both the cost of debt and the cost of equity must increase as more debt financing is used. This dependency of capital costs on capital structure means that as the weights are
542 Understanding Healthcare Finance Management
changed in the cost-of-capital calculation, so should the component However, it is very difficult, if not impossible, to estimate individual costs of debt and equity that correspond to the project’s optimal structure. Thus, capital structure adjustments quickly become futile guessing game, so most businesses do not make such adjustnn unless there are specific benchmark values that can be used for both ect’s unique debt capacity and the corresponding capital costs.7
SELF-TEST QUESTION
cost s.
Projcq capita
s°mewhat —
lents a proj-
1. Discuss the advantages and disadvantages of incorporating debt capacity differences into the capital budgeting decision process.
Adjusting Cash Outflows for Risk
Although most projects are evaluated on the basis of profitability, some proj- ects are evaluated solely on the basis of costs. Such evaluations arc done when it is impossible to allocate revenues to a particular project or when two com- peting projects will produce the same revenue stream. For example, suppose that Ridgeland must choose one of two ways of disposing its medical waste. There is no question about the necessity of the project, and neither method will affect the hospital’s revenue stream. In this situation, the decision will be based on the present value of expected future costs; the method with the lower present value of costs will be chosen.
Exhibit 12.7 lists the projected annual costs associated with each method. A large expenditure would be required at Year 0 to upgrade the hospital’s current disposal system, but the yearly operating costs would be relatively low. Conversely, if Ridgeland contracts for disposal services with an outside contractor, it will have to pay only $25,000 up front to initiate the contract. However, the annual contract fee would be $200,000 a year. Note that inflation effects are ignored in this illustration to simplify the discussion.
If both methods were judged to have average risk, Ridgeland’s corpo- rate cost of capital—10 percent—would be applied to the cash flows to obtain the present value (PV) of costs for each method. Because the PVs of costs for tire two waste disposal systems—$784,309 for the in-house system and $783,157 for the contract method—are roughly equal at a 10 percent discount rate, Ridgeland’s managers would be indifferent as to which method should be chosen if they were basing the decision on financial considerations only.
However, Ridgeland’s managers actually believe that the contract method is much riskier than the in-house method. They know the cost of modifying the current system to the dollar, and they can predict operating costs fairly well. Furthermore, the in-house system’s operating costs are under the control of Ridgeland’s management. Conversely, if the hospital
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Cash Flows
Year In-House System Outside Contract
0 ($500,000) ($ 25,000) 1 (75»ooo) (200,000) 2 (75.ooo) (200,000) 3 (75.ooo) (200,000) 4 (75.ooo) (200,000) 5 (75.ooo) (200,000)
EXHIBIT 12.7 Ridgeland Community Hospital: Waste Disposal Analysis
Present value of costs at a discount rate of:
10% ($784,309) ($ 783,157) 14% - ($ 711,616) 6% - ($867,473)
relies on the contractor for waste disposal, it more or less will have to con- tinue the contract because it will not have the in-house capability. Because the contractor was willing to guarantee the price only for the first year, perhaps the bid was lowballed and large price increases will occur in future years. The two methods have about the same PV of costs when both are considered to have average risk, so which method should be chosen if the contract method is judged to have high risk? Clearly, if the costs are the same under a common discount rate, the lower-risk in-house project should be chosen.
Now, try to incorporate this intuitive differential risk conclusion into the quantitative analysis. Conventional wisdom is to increase the corporate cost of capital for high-risk projects, so the contract cash flows would be dis- counted using a project cost of capital of 14 percent, which is the rate that Ridgeland applies to high-risk projects. However, at a 14 percent discount rate, the contract method has a PV of costs of only $711,616, which is about $70,000 lower than that for the in-house method. If the discount rate on the contract method’s cash flows were increased to 20 percent, an even greater amount, it would appear to be $161,000 cheaper than the in-house method. Thus, the riskier the contract method is judged to be, the better it looks.
Something is obviously wrong here! For a cash outflow to be penal- ized for higher-than-average risk, it must have a higher present value, not a lower one. Therefore, a cash outflow that has higher-than-average risk must be evaluated with a lower-than-average cost of capital. Recognizing this, Ridgeland’s managers applied a 10% - 4% = 6% discount rate to the high- risk contract method’s cash flows. The result is a PV of costs for the contract method of $867,473, which is about $83,000 more than the PV of costs for the average-risk in-house method.
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The appropriate risk adjustment for cash outflows is also applied other situations. For example, the City of Detroit offered Ann Arbor H Care Inc. the opportunity to use a city-owned building in a blighted area** a walk-in clinic. The city offered to pay to refurbish the building, and all^ its made by the clinic would accrue to Ann Arbor. However, after ten Ann Arbor would have to buy the building from the city at the then-cunj market value. The market value estimate that Ann Arbor used in its analvI was $2 million, but the realized cost could be much greater, or much 1 depending on the economic condition of the neighborhood at that time The project’s other cash flows were of average risk, but this single outflow »■ ’’ dSi high risk, so Ann Arbor lowered the discount rate that it applied to this one cash flow. This action created a higher present value for the $2 million cost (outflow) and hence lowered the project’s NPV.
The bottom line here is that risk adjustment for cash outflows is the opposite of adjustment for cash inflows. When cash outflows are being evalu- ated, higher risk calls for a lower discount rate.8
SELF-TEST QUESTIONS 1. Why are some projects evaluated on the basis of present value of
costs? 2. Is there any difference between the risk adjustments applied to
cash inflows and cash outflows? Explain your answer. 3. Can differential risk adjustments be made to single cash flows,
or must the same adjustment be made to all of a project’s cash flows?
Real (Managerial) Options
According to traditional capital budgeting analysis techniques, a project’s NPV is the present value of its expected future cash flows when discounted at an opportunity cost rate that reflects the riskiness of those flows. However, as discussed in Chapter 11 in the section on strategic value, such valuations generally do not incorporate the value inherent in additional actions that the business can take only if the project is accepted. In other words, traditional capital budgeting can be likened to playing roulette: A bet is made (the proj- ect is accepted) and the wheel is spun, but nothing can be done to influence the outcome of the game. In reality, capital projects are more like draw poker: Chance does play a role, but the players can influence the final result by dis- carding the right cards and assessing the other players’ actions.
The opportunities that managers have to change a project in response to changing conditions or to build on a project are called real, or manager^'
Chapter 12: Project Risk Analysis 545
options. These terms denote that such options arise from investments in real, rather than financial, assets and that the options are available to managers of businesses as opposed to individual investors. To illustrate the concept of real options, we first introduce decision tree analysis.
Decision Tree Analysis Although risk analysis is an integral part of capital budgeting, managers are at least as concerned (or maybe more concerned) about managing risk than they are about measuring it. One way of managing risk is to structure large projects as a series of decision points that provide the opportunity to reevalu- ate decisions as additional information becomes available, and possibly to cancel—or once it begins, to abandon—the project if events take a turn for the worse.
Projects that are structured as a series of decision points over time are evaluated using decision trees. For example, suppose Medical Equipment International (MEI) is considering the production of a new and innovative intensive care monitoring system. The net investment for this project is bro- ken down into three stages, as set forth in Exhibit 12.8. If the go-ahead is given for stage 1 (Year 0), the firm will conduct a $500,000 study of the mar- ket potential for the new monitoring system, which will take about one year. If the results of the study arc unfavorable, the project will be canceled, but if the results are favorable, MEI will (at Year 1) spend $1 million to design and fabricate several prototype systems. These systems will then be tested at two hospitals, and MEI will base its decision to proceed with full-scale production on their medical staffs’ reactions to them.
If their reactions are positive, MEI will establish a production line for the monitoring systems at one of its plants at a net cost of $10 million. If
this stage is reached, MEI’s managers estimate that the project will generate net cash flows over the following four years that will depend on the vitality of
the hospital industry at that time and the overall performance of the system. A decision tree such as the one in Exhibit 12.8 often is used to analyze
such multistage, or sequential, decisions. Here, for simplicity, let’s assume that one year goes by between decisions. Each circle represents a decision point or stage. The dollar value to the left of each decision point represents the net investment required to go forward at that decision point, and the cash flows under the t = 3 to t = 6 headings represent the cash inflows that would occur if the project is carried to completion. Each diagonal line represents the beginning of a branch of the decision tree, and each carries a probability that MEI’s managers estimate on the basis of the information available to them today. For example, management estimates that there is a probability °f0.8 that the initial study will produce favorable results, which would lead to the expenditure of $1 million at stage 2, and a 0.2 probability that the
cn -> Os
EXHIBIT 12.8 Decision Tree Analysis (in thousands of dollars)
Time
J = 0 t = 7 Z = 2 t = 3 t = 4 t = 5 t = 6 Joint
Probabilit y
NPV Product:
Prob, x NPV
$10,000 $10,000 $10,000 $10,000 0.144 $15,250 $2,196
($10,000) <0/ 0.4 $ 4’000
$ 4,000 $ 4,000 $ 4,000 0.192 436 84
Ay ($1,000)
<2) ($ 2,000) ($ 2,000) ($ 2,000) ($ 2,000) 0.144 (14,379) (2,071)
($500) Stop 0.320 (1,397) (447)
A. v>\ Stop 0.200
1.000 (500)
Expected NPV (100)
= ($ 338)
ctnpv = $7,991
U nderstanding H
ealthcare Finance M anagem
ent
Chapter 12: Project Risk Analysis
547
initial study will produce unfavorable results, which would lead to cancella- gon after stage 1.
The joint probabilities shown in Exhibit 12.8 give the probability of occurrence of each final outcome—that is, the probability of moving com- pletely along each branch. Each joint probability is obtained by multiplying together all the probabilities along a particular branch. For example, if stage I is undertaken, the probability that MEI will move through stages 2 and 3 and that a strong demand will produce $10 million in net cash flows in each of the next four years is 0.8 x 0.6 x 0.3 = 0.144 = 14.4%.
The NPV of each final outcome is also given in Exhibit 12.8. MEI has a corporate cost of capital of 11.5 percent, and its management assumes initially that all projects have average risk. For example, the NPV of the top branch (the most favorable outcome) is about $15,250 (in thousands of dollars):
NPv = (gs00 $10,000 $10,000 $10,000 (1.115)1 (1.115)2 (1.115)3 (1.115)4
$10,000 $10,000 + (1.115)5 + (1.115)6
= $15,250.
Other NPVs are calculated similarly. The last column in Exhibit 12.8 indicates the product of the NPV for each branch and the joint probability that that branch will occur, and the sum of the NPV products is the expected NPV of the project. Considering the expectations set forth in Exhibit 12.8, and assuming a cost of capital of 11.5 percent, we determine that the monitoring equipment project’s expected NPV is -$338,000.
Because the expected NPV is negative, it appears that this project would be unprofitable and hence should be rejected by MEI unless other considerations prevail. However, this initial judgment may not be correct. MEI must now consider whether this project is more, less, or about as risky as the firm’s average project. The expected NPV is a negative $338,000, and the standard deviation of NPV is $7,991,000, so the coefficient of variation of NPV is $7,991,000/$338,000 = 23.6, which is quite large. (Note that the negative sign for NPV does not enter into the calculation.) The value for the coefficient of variation suggests that the project is highly risky in terms of stand-alone risk. Note also that there is a 0.144 + 0.320 + 0.200 = 0.664 = 66.4% probability of incurring a loss. On the basis of these findings, the project appears to be unacceptable financially unless it has some embedded real options that will increase its value and/or reduce its risk.
548 Understanding Healthcare Finance Management
On the web at: ache.org/books/
UHFM/
The Real Option of Abandonment
Abandonment, which is discussed in Chapter 11 in connection with estirria • ing a project’s economic life, is one type of real option that many projcc possess. For an illustration of this real option’s impact, suppose that MEI 1 not contractually bound to continue the project once production has begun Thus, if sales are poor during Year 3 (t = 3), if MEI experiences a cash flow loss of $2 million, and if similar results are expected for the remaining three years, MEI can abandon the project at the end of Year 3 rather than continue to suffer losses. In this situation, low first-year sales signify that the monitor- ing equipment is not selling well, so future sales will also be poor, and ME] can act on this new information when it becomes available.
MEI’s ability to abandon the project changes the branch of the deci- sion tree that contains the series of $2 million losses in Exhibit 12.8. It now appears as follows (in thousands of dollars):
($2,000) @ Stop
Joint Product: Probability NPV Prob.x NPV
0.144 (10,8 8 3) (1,567)
Changing this branch to reflect abandonment eliminates the $2 mil- lion cash losses in years 4, 5, and 6 and thus causes the NPV for the branch to be higher, although still negative. This change increases the project's expected NPV from -$338,000 to about $166,000 and lowers the project’s standard deviation from $7,991,000 to $7,157,000. Thus, the abandonment real option changes the project’s expected NPV from negative to positive and also lowers its stand-alone risk as measured either by standard deviation or by coefficient of variation of NPV.
We can use the data just developed to estimate the value of the aban- donment option. The NPV with the abandonment option is $166,000, while the NPV without this option is -$338,000, so the value of the real option is $166,000 - (-$338,000) = $504,000. However, this value understates the true value of the option because the ability to abandon the project also lowers the riskiness of the project. With lower risk, the difference between the two NPVs is greater than that calculated, although the added value of risk reduc- tion would be relatively small in this illustration as well as difficult to quantify with confidence. Because of this and similar complications, discounted cash flow techniques (when they can be used to value real options) generally will not produce an accurate estimate of the option’s value.
Here are some additional points to note concerning decision tree analysis and abandonment:
Chapter 12: Project Risk Analysis 549
, Managers can reduce project risk if they can structure the decision process to include several decision points rather than just one. If MEI were to make a total commitment to the monitoring equipment project at t = 0 and sign contracts that would require completion of the project, it might save some money and accelerate the project, but doing so would substantially increase the project’s riskiness.
• Once production or service begins, a business’s ability to abandon a project can dramatically reduce the project’s risk.
• The cost of abandonment generally is reduced if the firm has alternative uses for the project’s assets. If MEI can convert the abandoned monitoring equipment production line to a different, more productive use, the cost of abandonment would be reduced and the monitoring equipment project would become more attractive.
Finally, note that capital budgeting is a dynamic process. Virtually all inputs to a capital budgeting decision change over time, and firms must peri- odically review both their expenditure plans and their ongoing projects. In the MEI example, conditions might change between decision points 1 and 2; if they do, this new information should be used to revise the probability and cash flow estimates. If a capital budgeting decision can be structured with multiple decision points, including abandonment, and if the firm’s manag- ers have the fortitude to admit when a project is not working out as initially planned, risks can be reduced and expected profitability can be increased.
Other Real Options The MEI monitoring system project demonstrates that the real option of abandonment can add value to a project. In addition to abandonment, there are many other types of real options.
Flexibility Options The flexibility option allows managers to switch inputs between alternative production or service processes. For example, by training clinical personnel to perform multiple tasks, individuals hired for a new service can potentially be used productively in other parts of the business. Thus, labor costs associ- ated with the new service can be easily reduced if demand estimates are not met. This flexibility option reduces costs in poor utilization scenarios and hence increases the value of the project.
Capacity Options The capacity option allows businesses to manage their productive capacity in response to changing market conditions. If a project can be structured so that its operations can be reduced or suspended if warranted rather than completely
550 Understanding Healthcare Finance Management
shut down, the value of the project increases. The option to expand new c. ** MT
vices from a relatively small scale to a large scale also adds value.
On the web at: ache.org/books/
UHFM7
New Service Options It is easy to envision a situation in which a negative NPV project is accepted because embedded in it is an option to add complementary services or suc- cessive “generations of services.” A managed care organization’s first move into a new geographic area and the introduction of transplant services at a hospital are two examples. In such situations, the first project may not be profitable, but it can lead to additional opportunities that are.
Timing Options In our examples thus far, new projects brought with them embedded real options that could be exercised in the future and hence added value to the project. Timing options can be somewhat different in that in some circum- stances they involve extinguishing existing real options. Timing options were first analyzed in situations involving natural resources, such as when to har- vest a forested area or how much oil to pump out of a well. By harvesting or pumping now, the project can produce immediate cash flows, but doing so eliminates the opportunity to obtain future cash flows from the same resource.
Of most interest to healthcare businesses is the option to delay, which is another type of timing option. If a project can be postponed, it might be more valuable in the future because, for example, managed care power is diminishing, technology is advancing, or information that will decrease the project’s risk is expected to become available. Of course, the option to delay is valuable only if it is worth more than the costs of delaying, which include time value of money costs, costs associated with competitor actions, and patient satisfaction costs. Thus, in general, the option to delay is most valu- able to businesses that have proprietary technology or some other barrier to entry that lessens the costs associated with postponement.
Valuation of Projects That Have Real Options In general, the true value of a project with real options can be thought of as the discounted cash flow (DCF) NPV plus the value of the real options:
True NPV = DCF NPV + Value of real options.
In most healthcare situations, a dollar value cannot be placed on any real options associated with a project. However, managers should still think about the value of many projects in terms of the above equation. Here are some points to consider:
Chapter 12: Project Risk Analysis 551
• Real options can add considerable value to many projects, so failure to consider such options leads to downward-biased NPVs and thus to systematic underinvestment.
• In general, the longer a real option lasts before it must be “exercised,” the more valuable it is. For example, suppose the real option is to expand into related services, such as expanding rehabilitative services into sports medicine services. The longer the expansion can be delayed and still retain its value, the more valuable the option.
• The more volatile the value of the underlying source of the real option, the more valuable the option. Thus, the more return volatility there is in the return on sports medicine services, the greater the value of a real option to expand into such services.
• The higher the cost of capital (the higher the general level of interest rates), the more valuable the real option. This point is not intuitive, but we explain the rationale in Chapter 18 (available online) in our discussion of stock options.
1. How can the possibility of abandonment affect a project’s profitability and stand-alone risk?
2. What are the costs and benefits of structuring large capital budgeting decisions in stages rather than in a single decision?
3. Why might DCF valuation underestimate the true value of a project?
4. What are some different types of real options? 5. How does the presence of real options influence capital budgeting
decisions?
SELF-TEST QUESTIONS
An Overview of the Capital Budgeting Decision Process
The discussion of capital budgeting thus far has focused on how managers evaluate individual projects. For capital planning purposes, healthcare manag- ers also need to forecast the total number of projects that will be undertaken and the dollar amount of capital needed to fund these projects. The list of projects to be undertaken is called the capital budget, and the optimal selec- tion of new projects is called the optimal capital budget.
While every healthcare provider estimates its optimal capital budget in its own way, some procedures are common to all businesses. We use the procedures followed by CALFIRST Health System to illustrate the process:
552 Understanding Healthcare Finance Management
The CFO estimates the system’s corporate cost of capital. As disc in Chapter 9, this estimate depends on market conditions, the busin^^ risk of CALFIRST’s assets in the aggregate, and the systemwide optimal capital structure.
• The CFO then scales the corporate cost of capital up or down to reflect the unique risk and capital structure features of each division Assume that CALFIRST has three divisions: LRD (low-risk division) ARD (average-risk division), and HRD (high-risk division).
• Managers in each of the divisions evaluate the riskiness of the proposed projects to their divisions by categorizing each project as LRP (low-risk project), ARP (average-risk project), or HRP (high-risk project). These project risk classifications are based on the riskiness of each project relative to the other projects in the division, not to the system in the aggregate.
• Each project is then assigned a project cost of capital that is based on the divisional cost of capital and the project’s relative riskiness. As discussed previously, this project cost of capital is then used to discount the project’s expected net cash flows. From a financial standpoint, all projects with positive NPVs are acceptable, while those with negative NPVs should be rejected. Subjective factors are also considered, and these factors may prompt a decision that differs from the one established solely on the basis of financial considerations.
Exhibit 12.9 summarizes CALFIRST’s overall capital budgeting pro- cess. Here, the corporate cost of capital, 10 percent, is adjusted upward to 14 percent in the HRD and downward to 8 percent in the LRD. The same adjustment—4 percentage points upward for HRPs and 2 percentage points downward for LRPs—is applied to differential risk projects in each division. The end result is a range of project costs of capital within CALFIRST that runs from 18 percent for HRPs in the HRD to 6 percent for LRPs in the LRD.
The result is a financial analysis process that incorporates each project’s debt capacity, at least at the divisional level, and riskiness. However, managers also must consider other possible risk factors that may not have been included in the quantitative analysis. For example, could the project being evaluated significantly increase the business’s liability exposure? Conversely, does the project have any real option value, social value, or other attributes that could affect its profitability or riskiness? Such additional factors must be considered, at least subjectively, before a final decision can be made. (A framework for considering multiple decision factors—the project scoring approach—is dis- cussed in Chapter 11.) Typically, if the project involves new products or ser- vices and is large (in capital requirements) relative to the size of the business s average project, the additional subjective factors will be important to the final
Chapter 12: Project Risk Analysis 553
Corporate cost of capital = 10%
High-risk project
HRD cost of capital = 14% Average-risk project
Low-risk project
High-risk project
ARD cost of capital = 10% Average-risk project
Low-risk project
High-risk project
LRD cost of capital = 8% Average-risk project
18%
14%
12%
14%
10%
8%
12%
8%
Low-risk project
EXHIBIT 12.9 CALFIRST: Divisional and Project Costs of Capital
6%
decision; one large mistake can bankrupt a firm, so “bet-the-firm” decisions are not made lightly. On the other hand, a decision on a small replacement project would be made mostly on the basis of numerical analysis.
Ultimately, capital budgeting decisions require an analysis of a mix of objective and subjective factors such as risk, debt capacity, profitability, medi- cal staff (patient) needs, real option value, and social value. The process is not precise, and often there is a temptation to ignore one or more important fac- tors because they are so nebulous and difficult to measure. Despite this impre- cision and subjectivity, a project’s risk, as well as its other attributes, should be assessed and incorporated into the capital budgeting decision process.
1. Describe a typical capital budgeting decision process. 2. Are decisions made solely on the basis of quantitative factors?
Explain your answer.
SELF-TEST QUESTIONS
Capital Rationing
Standard capital budgeting procedures assume that businesses can raise virtu- ally unlimited amounts of capital to meet capital budgeting needs. Presumably,
554 Understanding Healthcare Finance Management
as long as a business is investing the funds in profitable (i.e., positive J projects, it should be able to raise the debt and equity needed to fund a|j projects. Additionally, standard capital budgeting procedures assume h business raises the capital needed to finance its optimal capital budget ro in accordance with its target capital structure and at an average cost equj the estimated corporate cost of capital.
This picture of a business’s capital financing/capital investment 1 cess is probably appropriate for large investor-owned firms in most situatio J However, not-for-profit firms and small investor-owned businesses typically dt not have unlimited access to capital. Their ability to raise equity capital often is limited, and their debt capital is constrained to the amount supported by the equity capital base. Thus, such businesses will likely face periods in which the capital needed for investment in worthwhile new projects will exceed the amount of capital available. This situation is called capital rationing.
If capital rationing exists (i.e., a business has more acceptable projects than capital), from a financial perspective the business should accept the set of capital projects that maximizes aggregate NPV and still meets the capital constraint. This approach can be called “getting the most bang for the buck” because it picks projects that have the most positive impact on the business’s financial condition.
Another ROI measure—the profitability index (PI)—is useful in a capital rationing situation. The PI is defined as the PV of cash inflows divided by the PV of cash outflows. Thus, for Ridgeland’s MRI project discussed earlier in the chapter, PI = $2,582,493/$2,500,000 = 1.03. The PI measures a project’s dollars of profitability per dollar of investment, all on a PV basis. The MRI project promises three cents of profit for every dollar invested, which indicates it is not very profitable. (The PI of 1.03 is before adjusting for risk. After adjusting for risk, the project’s PI is less than 1.00, indicating that the project is unprofitable.) In a capital rationing situation, the optimal capital budget is determined by first listing all profitable projects in descend- ing order of PI. Then, projects are selected from the top of the list downward until the capital available is used up.
Of course, in healthcare businesses, priority may be assigned to some low or even negative NPV projects, which is fine as long as these projects arc offset by the selection of profitable projects, which would prevent the low- profitability priority projects from eroding the business’s financial condition.
SELF-TEST QUESTIONS 1. What is capital rationing?
2. From a financial perspective, how arc projects chosen when capital rationing exists?
3. What is the profitability index, and why is it useful in a capital rationing situation?
Chapter 12: Project Risk Analysis 555
Chapter Key Concepts f his chapter discussed project risk definition, assessment, and incorpora- tion. Here are its key concepts:
• There are three types of project risk-. (1) stand-alone risk, (2) corporate risk, and (3) market risk.
• A project’s stand-alone risk is the risk the project would have if it were the sole project of a not-for-profit firm. It is measured by the variability of profitability, generally by the standard deviation or coefficient of variation of NPV. Stand-alone risk often is used as a proxy for corporate and market risk because (1) corporate and market risk are often impossible to measure and (2) the three types of risk are usually highly correlated.
• Corporate risk reflects a project’s contribution to the overall riskiness of the business. It is measured conceptually by the project’s corporate beta. Corporate risk ignores stockholder diversification and is relevant to not-for-profit firms.
• Market risk reflects the contribution of a project to the overall riskiness of the owners’ well-diversified investment portfolios. It is measured conceptually by the project’s market beta. In theory, market risk is relevant to investor-owned firms, but many people argue that corporate risk is also relevant to owners, especially the owners/managers of small businesses, and it is certainly relevant to a business’s other stakeholders.
• Three quantitative techniques are commonly used to assess a project’s stand-alone risk-. (1) sensitivity analysis, (2) scenario analysis, and (3) Monte Carlo simulation.
• Sensitivity analysis shows how much a project’s profitability—for example, as measured by NPV—changes in response to a given change in an input variable such as volume, other things held constant.
• Scenario analysis defines a project’s best, most likely, and worst possible outcomes and then uses these data to measure its stand- alone risk.
• Whereas scenario analysis focuses on only a few possible outcomes, Monte Carlo simulation uses continuous distributions to reflect the uncertainty inherent in a project’s component cash flows. The result is a probability distribution of NPV, or IRR, that provides a great deal of information about the project’s riskiness.
(continued)
556 Understanding Healthcare Finance Management
(continued from previous page) • In addition to quantitative risk assessment techniques, the
qualitative approach uses the answers to yes/no questions to assess project risk.
• Projects that require capital oudays in stages over time often are evaluated using decision trees. The branches of the tree represent different outcomes, and, when subjective probabilities are assigned to the outcomes, the tree provides the profitability distribution for the project.
• In addition to the DCF-calculated NPV, some projects have additional value in the form of embedded real (managerial) options.
• One type of real option is the ability’ to abandon a project once operations have begun. This option can both increase a project’s dollar return and decrease its riskiness and thus has a twofold positive effect on value.
• There are two methods for incorporating project risk into the capital budgeting decision process: (1) the certainty equivalent (CE) method, which adjusts a project’s expected cash flows to reflect project risk, and (2) the risk-adjusted discount rate (RADR) method, which deals with differential risk by changing the cost of capital.
• Projects are generally classified as high risk, average risk, or low risk on the basis of their stand-alone risk assessment. High-risk projects are evaluated at a discount rate greater than the firm’s corporate cost of capital, average-risk projects are evaluated at the corporate cost of capital, and low-risk projects are evaluated at a rate less than the corporate cost of capital. In a business with divisions, the risk- adjustment process often takes place at the divisional level.
• In the evaluation of risky cash outflows, the risk adjustment process is reversed—that is, lower rates are used to discount more risky cash flows.
• Ultimately, capital budgeting decisions require an analysis of a mix of objective and subjective factors such as risk, debt capacity, profitability, medical staff needs, real option value, and social value. The process is not precise, but good managers do their best to ensure that none of the relevant factors is ignored.
Chapter 12: Project Risk Analysis 557
.Ina capital rationing situation, the business has more profitable projects than investment capital. In such cases, the profitability- index (PI) is a useful measure of profitability (ROI).
This concludes our discussion of capital budgeting. In chapters 13 and 14, we discuss financial and operating analyses and financial forecasting.
Chapter Models, Problems, and Mini-Cases
The following ancillary resources in spreadsheet format are available for this chapter:
• A chapter model that shows how to perform many of the calculations described in the chapter
• Problems that test your ability to perform the calculations • A mini-case that is more complicated than the problems and tests your
ability to perform the calculations in preparation for a case
These resources can be accessed on the book’s companion website at ache.org/books/UHFM7.
Selected Cases
Our discussion of capital budgeting is now complete. Several cases in Cases in Healthcare Finance, 5th edition, can be used at this point:
• Case 20: Coral Bay Hospital, which focuses on a “bread and butter” capital budgeting analysis of a proposed ambulatory surgery center
• Case 21: National Rehabilitation Centers, which requires a staged entry (decision tree) analysis
• Case 22: Northwest Suburban Health System, which involves a make- or-buy analysis regarding a health system’s printing services
• Case 27: Jones Memorial Hospital, which focuses on evaluation of competing technologies with backfill
558 Understanding Healthcare Finance Management
Selected Bibliography
Kaufman, K. 2008. “Managing Risk in a Challenging Financial Environment- Healthcare Financial Management 62 (8): 45-50.
Williams, D. R., and P. H. Hammes. 2007. “Real Option Logic for Healthcare Entrepreneurial Growth and Survival.” Healthcare Financial Manager,lcr. 61 (5): 76-79.
----------. 2007. “Real Options Reasoning in Healthcare: An Integrative Approach and Synopsis.” Journal of Healthcare Management 52 (3): 170-87.
Selected Websites
• Several spreadsheet add-on software packages that perform Monte Carlo simulation are available. A demonstration version of one, called @RISK, can be downloaded from www.palisade.com. Click on the Free Trial Download tab at the top left of the page.
• Similarly, a free trial download of decision tree software Precision Tree is available from the same link. As discussed in the chapter, it can be used to make decisions whose consequences have multiple stages.
Notes
1. The three types of risk relevant to capital budgeting decisions are first discussed in Chapter 5. A review of the applicable sections may be beneficial to some readers.
2. For an algebraic presentation of the relationships between the three types of risk, see Gapenski, L. C. 1992. “Project Risk Definition and Measurement in a Not-for-Profit Setting.” Health Services Management (November): 216-24.
3. Spreadsheet programs have Data Table functions that automatically perform sensitivity analyses. After the table is roughed in, the spreadsheet automatically calculates and records a project’s NPV, or some other value, in the appropriate cells in the table. This feature is explained in the Chapter 12 model, which can be accessed on this book’s companion website at ache.org/books/UHFM7.
4. Skewness measures the degree of symmetry of a distribution. A skewness of zero indicates a symmetric distribution, positive skewness indicates a distribution that is skewed to the right (its right tail is longer than its left), and negative skewness indicates a distribution that is skewed to
Chapter 12: Project Risk Analysis 559
the left (its left tail is longer than its right). The absolute value of the number indicates the degree of skewness—the larger the number, the more skewed the distribution.
5 Economists use utility theory to explain how individuals make choices among risky alternatives.
5 The risk-free rate does not incorporate the tax advantage of debt financing, so such benefits to taxable firms should be incorporated directly into the cash flows when the CE method is used. Alternatively, the discount rate can be determined using the corporate cost-of-capital formula, but with the risk-free rate in place of the costs of debt and equity. The discount rate calculated in this way is the risk-free rate with the tax advantage included, so it can be applied to the CE cash flows without tax adjustments.
7. Debt capacity adjustments are often made in project financing. In this type of financing, lenders provide debt capital solely on the basis of the earnings power of the project because they have limited or no recourse against the business’s other cash flows. In this situation, there is a readily identifiable cost of debt and debt capacity for the project.
8. What happens when the cash flows being discounted include both inflows and outflows so that the proper risk adjustment is not obvious? The solution is to try an adjustment and see what happens. For example, if the corporate cost of capital is 10 percent and the mixed cash flow project is judged to have high risk, discount the cash flows at 14 percent. If the NPV of the project increases, the adjustment clearly is wrong because an adjustment for high risk should penalize the project. Thus, the correct adjustment is to decrease the cost of capital—say, to 6 percent.
560 Understanding Healthcare Finance Management
Integrative Application
The Problem
Zachary Taylor Managed Care (ZTMC) is considering expanding into the Atlanta market. The company is a comprehensive managed care organization and has discovered that several large employers in the area are highly dissatisfied with their current managed care organizations. ZTMC estimates that getting into the Atlanta market will require an initial capital investment of $150 million that will have an estimated life often years. However, there is substantial uncertainty around the size of the managed care market, what share of the managed care market ZTMC will be able to attract, the unit price that can be charged, the unit variable utilization cost, and the annual fixed costs. ZTMC uses straight-line depreciation, has a corporate cost of capital of 10 percent, and pays taxes at a rate of 50 percent. Management has prepared the following forecast:
Pessimistic Expected Optimistic
Market size 900,000 1,000,000 1,100,000 Market share 4% 10% 16%
Unit price $ 3,500 $ 3,750 $ 3,800
Unit variable cost $ 3,600 $ 3,000 $ 2,750 Fixed cost $40,000,000 $30,000,000 $20,000,000
What source of uncertainty in the capital investment decision should ZTMC be most concerned about?
The Analysis
The first step is to calculate the estimated net cash flow from the investment.
Annual Cash Flow (in millions of dollars)
""^Revenue: (1,000,000 market size x 10% market share x $3,750 unit price)
= $375-oo
2. Variable cost: (1,000,000 market size x 10% market share x $3,750 unit vc)
= $300.00
3. Fixed cost $ 30.00 4. Depreciation: ($150,000,000 110-year life) = $ 15.00
5. Pretax profit: (Lines 1 - 2 - 3 - 4) = $ 30.00 6. Tax: (Line 5) x 50% = $ 15.00
7. Net profit: (Lines 5-6) = $ 15.00 8. Operating cash flow: (Lines 4+ 7) = $ 30.00 The expected NPV of the investment is = - PV (10%, 10, $30) + ($150) = $ 34.30 million.
Now, suppose the market size is 900,000 instead of the expected 1,000,000 (and all else remains the same). The estimated net cash flow from the investment becomes:
Annual Cash Flow (in millions of dollars)
1. Revenue: (900,000 market size x 10% market share = $337-50 x $3,750 unit price)
2. Variable cost: (900,000 market size x 10% market = $270.00 share x $3,750 unit vc)
3. Fixed cost $ 30.00 4. Depreciation: ($150,000,000 / 10-year life) = $ 15.00
5. Pretax profit: (Lines 1-2-3-4) = $ 22.50 6. Tax: (Line 5) x 50% = $ 11.25
7- Net profit: (Lines 5-6) = $ 11.25
8. Operating cash flow: (Lines 4 + 7) = $ 26.25 The expected NPV of the investment becomes = PV (10%, 10, $26.25) + ($150) = $11.29 million.
562 Understanding Healthcare Finance Management
Changing one variable at a time and recalculating NPV produces the fo[. lowing table of expected NPVs:
Net Present Value
Pessimistic Expected Optimistic Market size $ 11.29 $34-3 $ 57-38 Market share ($103.92) $34-3 $172.59 Unit price ($ 42.47) $34-3 $ 49-70
Unit variable cost ($150.00) $34-3 $ 111.14 Fixed cost $ 3-6I $34-3 $ 65.06
The table shows that the sources of uncertainty that ZTMC should be most concerned about are market share and unit variable cost (and unit price, to a lesser extent). If market share is 4 percent instead of the expected 10 percent or if unit variable costs are $3,600 instead of the expected $3,000, expansion into the Atlanta market could produce very large negative NPVs to ZTMC.
The Decision
ZTMC decided to focus on (1) marketing—that is, approaching employers to ensure the expected market share—and (2) cost control—that is, using Lean and Six Sigma techniques to ensure that services are provided efficiently. ■
PARTr VI
FINANCIAL CONDITION ANALYSIS AND FORECASTING
In Part VI, we change our focus from capital acquisition and allocationdecisions to financial condition analysis and forecasting. Of all the ele-ments needed to effectively manage a healthcare organization’s financial performance, perhaps the two most important are (1) understanding the business’s current financial condition and (2) having a financial road map in place to move the business into the future.
The material in Part VI is divided into two chapters. Chapter 13 dis- cusses the tools used to assess a business’s financial condition. Much of this chapter is devoted to ratio analysis, which is the primary technique used in financial condition assessment. Chapter 14 covers the basic techniques used to forecast a business’s financial future with a focus on forecasting a business’s financial statements. Using the tools discussed in Chapter 13, managers can then examine the forecasted statements to assess the financial attractiveness of alternative business strategies.
CHAPTER
FINANCIAL CONDITION ANALYSIS 13 Learning Objectives After studying this chapter, readers should be able to
• explain the purposes of financial statement and operating indicator analyses,
• apply the primary techniques used in financial statement and operating indicator analyses,
• illustrate the problems associated with financial statement and operating indicator analyses,
• explain the economic value added model and its relevance to healthcare businesses,
• describe how key performance indicators and dashboards can be used to monitor financial condition, and
• use basic financial condition analyses to assess the financial performance of a business.
Introduction
Financial condition analysis is of vital concern to healthcare managers, secu- rity analysts, equity investors, and lenders. The purposes of such analyses are to assess the financial condition of a business and, perhaps more impor- tant, to identify the operating factors that led to that condition. In general, financial condition analysis is composed of three pieces. Financial statement analysis focuses on the data contained in a firm’s financial statements, such as revenues, operating costs, accounts receivable, and total assets. Operating indicator analysis focuses on operating factors, such as occupancy (census), patient mix, length of stay, and labor productivity. Finally, other analysis techniques—such as economic value added (EVA)—provide supplementary information about a business’s financial condition.
In this chapter, we discuss several techniques used to extract infor- mation from a firm’s financial statements (and elsewhere) and combine it ln a form that helps managers make judgments about a business’s financial condition and the operational factors that led to that condition. Often, the end result of such analyses is a list of a business’s strengths and weaknesses
565
566 Understanding Healthcare Finance Management
and, one hopes, a plan to correct any weaknesses identified. In additio ' discuss related topics, such as the problems inherent in such analyses Fo * most part, financial condition analysis is applied to historical data so ments made on the basis of this analysis reflect the results of past manag • decisions. However, the more interesting question is what the business w do in the future. Therefore, managers invariably use the analyses discusj in this chapter to help predict and plan for the future, which is the sub' of Chapter 14.
You will discover that financial condition analysis generates a great deal of data. A significant problem in assessing financial condition is presenting the results in a simple, easy-to-monitor format. Thus, we close the chapter with some ideas about data presentation.
Financial Reporting in the Health Services Industry
Financial reporting in all industries follows standards set forth by the account- ing profession, called generally accepted accounting principles (GAAP). The purpose of such standards is to ensure, to the extent possible, that financial information reported to outsiders is consistent across businesses and pre- sented in a manner that facilitates interpretation and judgments. Because the health services industry has many unique features, including a high pro- portion of not-for-profit businesses, there arc many organizations involved in setting reporting standards. Although the detail of establishing account- ing standards is beyond the scope of this text, note that such standards arc constantly being reviewed and modified as necessary to reflect changing economic conditions.
Accounting standards require businesses to prepare several financial statements, including three basic types: (1) income statement, (2) balance sheet, and (3) statement of cash flows. Taken together, these statements pro- vide an accounting picture of the firm’s operations and its financial position. Detailed data are provided for the two or three most recent periods; plus, brief historical summaries of key operating statistics for longer periods arc often included.
Depending on size and ownership, a business’s financial statements usually are made available to interested outside parties. Most large businesses prepare an annual report, which provides financial statements and a written description of the business’s operating results during the past year, along with a discussion of developments that will affect its future operations. In addi- tion, large investor-owned corporations must file even more detailed reports on an annual basis (a 10-K) and a quarterly basis (a 10-Q) with the Securi- ties and Exchange Commission (SEC). Finally, many larger firms publish statistical supplements, which include financial statement data and key ratios
Chapter 13: Financial Condition Analysis 567
from the past ten years or so. These reports—and similar reports that may be filed with state regulatory agencies—are often available from online sources, including the business itself.
Income Statement Exhibit 13.1 contains simplified forms of the 2013 and 2014 income state- ments (also called statements of operations or statements of revenues and. expenses') for Bayside Memorial Hospital, a 450-bed, not-for-profit, acute care hospital. Although a hospital is being used to illustrate financial condition analysis techniques, such techniques can be applied to any health services setting. Bayside had an excess of revenues over expenses, or net income, of $8,572,000 in 2014. Of course, being not-for-profit, the hospital paid no dividends, so it retained all of its net income. When looking at an income statement, we can get a rough idea of the organization’s cash flow, which is approximately equal to its net income plus any noncash expenses. In 2014, Bayside’s cash flow was $8,572,000 in net income plus $4,130,000 in depre- ciation expense, for a total estimated net cash flow of $12,702,000. Depre- ciation does not really provide funds; it is simply a noncash charge added back to net income to obtain an estimate of the business’s net cash flow. Later
2014 2013
Revenues: Patient service revenue $ 106,502 $ 95.398 Less: Provision for bad debts 3.328 3,469
Net patient service revenue $ 103,174 $ 91.929 Premium revenue 5.232 4,622 Other revenue 3.644 6,014
Total operating revenues $ 112,050 $102,565
Expenses: Nursing services $ 58,285 $ 56,752 Dietary services 5.424 4.718 General services 13.198 11,655 Administrative services n.427 11,585 Employee health and welfare 10,250 10,705
Malpractice insurance 1,320 1,204 Depreciation 4.130 4,025 Interest expense 1.542 1,521
Total expenses $ 105,576 $102,165 Operating income $ 6,474 $ 400 Nonoperating income 2,098 1,995
Net income $ 8,572 $ 2,395
EXHIBIT 13.1 Bayside Memorial Hospital State- ments of Opera- tions (Income Statements) Years Ended December 31, 2014 and 2013 (in thousands of dollars)
1 _____
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in this section, we will discuss the statement of cash flows, which provides better insight into Bayside’s cash flows.
Note that the income statement reports on transactions over a period—for example, during fiscal year 2014. (Note that Bayside’s fiscal year coincides with the calendar year.) The balance sheet, which we discuss next may be thought of as a snapshot of the firm’s asset, liability, and equity posi- tion at a single point in time—for example, on December 31, 2014.
Balance Sheet Exhibit 13.2 contains Bayside’s 2013 and 2014 balance sheets. Although the assets are stated in terms of dollars, only the amount of cash in the checking account represents actual money. We see that Bayside could, if it liquidated its cash equivalents and short-term investment securities, write checks at the end of 2014 for a total of $6,263,000 (versus total current liabilities of $13,332,000 due during 2014). The noncash current assets will presumably be converted to cash within a year, but they do not represent cash on hand.
The claims against assets are of two types: (1) liabilities, or money the firm owes, and (2) equity, also called net assets or fund capital) Equity is a residual, so for 2014,
Assets - Liabilities = Equity
$151,278,000 - ($13,332,000 + $30,582,000) = $107,364,000.
Liabilities consist of$l 3,332,000 of current liabilities plus $30,582,000 of long-term liabilities. If assets decline in value—suppose some of Bayside’s fixed assets were sold at less than book value—liabilities remain constant, so the value of the equity capital declines.
A business’s equity account is built up over time by retentions (retained earnings). In 2014, Bayside’s income statement reported a net income of $8,572,000. As a not-for-profit organization, none of the net income can be paid out in dividends, so the entire amount must be retained in the busi- ness. Barring any asset sales or revaluations, Bayside’s equity account should increase from year to year by the amount of net income. Thus,
2014 Equity balance = 2013 Equity balance + 2014 Net income
$107,364,000 = $98,792,000 $8,572,000.
Note that accumulated depreciation reported on the balance sheet is a contra asset account; that is, it is subtracted from gross property and
equipment, so the larger a firm’s accumulated depreciation, all else the same, the smaller its total assets. However, as noted earlier, the larger the amount
of depreciation in any year, the greater the business’s cash flow because
Chapter 13: Financial Condition Analysis 569
T" 2014 2013
Cash and equivalents $ 2,263 $ 3.095 Short-term investments 4,000 2,000 Net patient accounts receivable 21,840 20,738
Inventories 3477 2,982 Total current assets $ 31,280 $ 28,815
Gross property and equipment $145,158 $140,865
Accumulated depreciation 25,160 21,030 Net property and equipment $119,998 $119,835
Total assets $151,278 $148,650
Accounts payable $ 4.707 $ 5,145 Accrued expenses 5.650 5,421
Notes payable 2,975 6,237 Total current liabilities $ 13.332 $ 16,803
Long-term debt $ 28,750 $ 30,900
Capital lease obligations 1,832 2.155 Total long-term liabilities $ 30,582 $ 33,055
Net assets (equity) $107,364 $ 98.792
Total liabilities and net assets $151,278 $148,650
EXHIBIT 13.2 Bayside Memorial Hospital Balance Sheets December 31, 2014 and 2013 (in thousands of dollars)
depreciation is a noncash expense. Accumulated depreciation on the balance sheet increases each year by the amount of depreciation expense reported on the income statement. For example:
2014 accumulated
depreciation
$25,160,000
2013 accumulated
depreciation
$21,030,000
+ 2014 depreciation
expense
+ $4,130,000.
Statement ofCash Flows Some time ago, annual reports contained a statement called the sources and uses of funds statement. The purpose of the statement was to report the sources from which the business had obtained funds during the past year and how it had used them. For example, had the business obtained most of its funds from such sources as bank loans and bond issues or from retained earnings? Had it used those funds to retire debt, build new facilities, build up inventories, or pay dividends? One could look at the statement to see the
570 Understanding Healthcare Finance Management
total sources and total uses, which were equal, and how funds were obt ' and used, but there was no summary figure that could be used to i / whether the firm ended the year in a stronger or weaker financial position comparison to the previous year.
After several format revisions, organizations now report hind flow s the statement of cash flows, which typically is organized into three sections- (1) cash flow from operating activities, (2) cash flow from investing activp ties, and (3) cash flow from financing activities. Accountants adopted the new format because it provides fund flow information in a more useful wav
Exhibit 13.3 contains Bayside’s statement of cash flows, which focuses on the sources and uses of overall cash flow, for 2014. In the statement, cash coming into the hospital (inflows) is shown as positive numbers, while cash being spent (outflows) is shown as negative numbers (shown in parentheses; The top part lists cash generated by and used in operations. For Bayside operations provided $9,098,000 in net cash flow. The income statement reported $6,474,000 in operating income and $4,130,000 in depreciation, for $10,604,000 in operating cash flow. But as part of its operations, Bayside
EXHIBIT 13.3 Bayside
Memorial Hospital
Statement of Cash Flows Year
Ended Decem- ber 31, 2014 (in
thousands of dollars)
Cash flows from operating activities: Operating income $ 6,474 Adjustments: Depreciation 4430 Increase in accounts receivable (1,102) Increase in inventories (195) Decrease in accounts payable (438) Increase in accrued expenses 22J Net cash flow from operations $ 9,098
Cash flows from investing activities: Investment in property and equipment ($ 4,293)
Investment in short-term securities ( 2,000) Net cash flow from investing ($ 6,293)
Cash flows from financing activities: Nonoperating income $ 2,098 Repayment of long-term debt (2,150) Repayment of notes payable (3.262) Capital lease principal repayment (323) Net cash flow from financing ($
" 3.637)
Net increase (decrease) in cash and equivalents ($ 832)
Beginning cash and equivalents $ 3.095
Ending cash and equivalents $ 2i263
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invested $1,297,000 in current assets (receivables and inventories) and lost S209,000 in spontaneous liabilities (payables and accruals). The end result— nCt cash flow from operations—was $10,604,000 - $1,297,000 - $209,000 s $9,098,000.
The next section of the statement of cash flows focuses on investments in fixed assets (property and equipment) and in financial assets (securities). As noted in the statement, Bayside spent $4,293,000 on capital expenditures in 2014 and invested $2,000,000 in short-term securities, for a net cash outflow from investing of $6,293,000.
Bayside’s financing activities, as shown in the third section, highlight the fact that the hospital received $2,098,000 in nonoperating income (unre- stricted contributions and investment income) and used cash to pay off previ- ously incurred long-term debt, short-term debt, and capital lease obligations. The net effect of the hospital’s financing activities was a net cash outflow from financing oi $3,637,000.
When the three major sections are totaled, Bayside had a $9,098,000 - $6,293,000 - $3,637,000 = $832,000 net decrease in cash (i.e., net cash
outflow) during 2014. The bottom of Exhibit 13.3 reconciles the net cash flow with the ending cash balance shown on the balance sheet. Bayside began 2014 with $3,095,000 in cash and equivalents, experienced a net cash outflow of $832,000 during the year, and ended the year with $3,095,000
-$832,000 = $2,263,000 in its cash and equivalents account, as verified by the value reported in Exhibit 13.2.
Bayside’s statement of cash flows shows nothing unusual or alarming. It does show that the hospital’s operations are inherently profitable (gener- ated a positive cash flow), at least in 2014. Had the statement shown an oper- ating cash drain, Bayside’s managers would have had something to worry about; if it continued, such a drain could bleed the hospital to death. The statement of cash flows also provides information about Bayside’s financing and fixed-asset-investing activities for the year that is easy to interpret. For example, Bayside’s cash flow from operations was used primarily to purchase new fixed assets, invest in short-term securities, and pay off notes payable and long-term debt. Such uses of operating cash flow do not raise red flags regarding the hospital’s financial actions. In fact, Bayside’s ability to both increase securities investments and pay off debt while adding new fixed assets indicates that 2014 was a very good year financially.
Managers and investors must pay close attention to the statement of cash flows. Financial condition is driven by cash flows, and the statement pro- vides a good picture of the annual cash flows generated by the business.2 An examination of Exhibit 13.3 or, better yet, a series of such tables for the last five years and for five years into the future would give Bayside’s managers and creditors an idea of whether the hospital’s operations are self-sustaining; that is, does the business generate the cash flows necessary to pay its expenses,
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including those associated with raising capital? Although the statement of cash flows is filled with valuable infi-''•’nation, the bottom line tells little about the business’s financial condition because operating losses can be covered by financing transactions such as borrowing or selling new common stock (if investor owned), at least in the short run.
Notes to the Financial Statements The notes to the financial statements often contain information that can sig- nificantly affect a business’s financial condition. For healthcare providers these notes contain information on the firm’s pension plan, its malpractice insurance, the amount of charity care it provides, the types of debt financing it uses, its accounting policies, and so forth. Clearly, the information con- tained in the notes to the financial statements has a bearing on the business’s financial condition, and it should be considered, either directly or indirectly, in any financial statement analysis. To professional analysts, the notes are especially vital. Indeed, they occasionally use the notes information to recast financial statements before they even begin an analysis.
SELF-TEST QUESTIONS
SELF-TEST QUESTION
1. What governs financial reporting requirements in the health services industry?
2. Briefly describe these three basic financial statements: (1) income statement, (2) balance sheet, and (3) statement of cash flows.
3. What type of information does each type of statement provide? 4. What is the difference between net income and cash flow, and which is more meaningful to a firm’s financial condition? 5. What types of information are contained in the notes to a business’s financial statements?
Financial Statement Analysis
The first step in most financial condition analyses is to examine the business’s financial statements. Financial statement analysis involves a number of tech- niques that extract information contained in a business’s financial statements and then combine it in a form that helps managers make judgments about the firm’s financial condition. In the next sections, we discuss some common analytical techniques along with some problems inherent in such analyses.
1. What is financial statement analysis?
Chapter 13: Financial Condition Analysis 573
Ratio Analysis
Although a business’s income statement and balance sheet contain a wealth of financial information, it is often difficult to make meaningful judgments about financial performance by merely examining the raw data. For example, one managed care plan may have $5,248,760 in long-term debt and interest charges of $419,900, while another may have $52,647,980 in debt and inter- est charges of $3,948,600. The true burden of these debts, and each man- aged care plan’s ability to pay the interest and principal due on them, cannot be easily assessed without additional comparisons, such as those provided by ratio analysis. In essence, ratio analysis combines data from the balance sheet and the income statement to create single numbers whose financial significance is easily interpreted (i.e., numbers that measure various aspects of financial performance). In the case of debt and interest payments, ratios can be constructed that relate each plan’s debt to its assets and the interest it pays to the income it has available for payment.
Generally, ratios are grouped into four major categories to make them easier to interpret: profitability, liquidity, debt management, and asset man- agement. We use the data presented in exhibits 13.1 and 13.2 to calculate an illustrative sampling of financial ratios for 2014 for Bayside Memorial Hospital. To help in interpretation, the ratios are compared to hospital indus-
On the web at: ache.org/books/ UHFM7
try average ratios. Note that, in an actual analysis, many more ratios are calculated and analyzed. Also, the ratios used in an analysis depend on the type of healthcare provider being analyzed. Some ratios are more meaningful for hospitals, managed care organizations, group practices, and so on. Here, a hospital is used to illustrate ratio analysis.
Industry average ratios are available from many sources. For example, as men- tioned in the sidebar, Ingenix publishes an annual almanac that provides hospital industry data on 76 financial and oper- ating indicators (ratios). The ratios are reported in several groupings, such as by hospital size and geographic location. Go to www.optumcoding.com and search for “almanac.” Note that the industry aver- age ratios presented in this chapter are for illustrative use only and should not be
How Many Ratios Are Enough? In our discussion of financial statement ratio analysis, we include 14 ratios that are commonly used to help interpret financial statement data. Although that may seem like a lot of ratios, our discussion just scratches the surface. For exam- ple, one of the most widely used sets of com- parative data for hospitals—called the Almanac of Hospital Financial and Operating Indicators, published annually by Ingenix—provides data on more than 30 financial ratios.
Without too much additional work, you could probably compile a list of 50 financial ratios. Yet studies have shown that about 90 percent of the information contained in financial statements can be uncovered using ten or so carefully selected ratios.
How many ratios do you think are enough? Does it matter how the ratios are selected? Is there a cost to using more ratios than necessary? ________________________________________________
used to make real-world comparisons. Also note that, in accordance standard practice, we call the comparative data averages, but in reality ’ are median values. Median values are better for comparisons because th not biased by extremely high or low values in the industry data set
Profitability Ratios Profitability is the net result of a large number of managerial policies and decisions, so profitability ratios are one measure of a business’s aggrega^ financial performance.
Total Margin The total margin—often called the total profit margin or just profit margin— is defined as net income divided by total revenues:
Key Equation 13.1: Total Margin
Total margin = Net income
Total revenues $8,572 $114,148
= 0.075 = 7.5%.
Industry average = 5.0%.
Note that total revenues are defined here as total operating rev- enues plus nonoperating income, so Total revenues = $112,050 + $2,098 = $114,148. Bayside’s total margin of 7.5 percent shows that the hospital makes 7.5 cents on every dollar of total revenues. The total margin measures the organization’s ability to control expenses. With all else the same, the higher the total margin, the lower the expenses relative to revenues. Bayside’s total margin is above the industry average of 5.0 percent, which indicates good expense control. How good? The industry data source also reports quartiles; for total margin, the upper quartile was 8.4 percent, which means that 25 percent of hospitals had total margins higher than 8.4 percent. Thus, although Bayside’s total margin was better than average, it was not as good as the top hospitals’ total margins.
Bayside’s relatively high total margin may mean that the hospital’s gross charges are relatively high, its allowances are relatively low, its costs are relatively low, it has relatively high other (nonoperating) income, or some combination of these factors. A thorough operating indicator analysis would help pinpoint the cause, or causes, of Bayside’s high total margin.
Operating Margin Another useful margin measure is the operating margin, defined as operating income divided by patient-related (operating) revenues:
Chapter 13: Financial Condition Analysis 575
Key Equation 13.2: Operating Margin
Operating income $6,474 Operating marg Total operating revenues $112,050 Industry average = 3.5%.
= 0.058 = 5.8%.
The advantage of this margin measure is it focuses on the primary business line of the enterprise. Thus, it removes the influence of nonoperat- ing income, which often is transitory and more related to stock and bond market conditions than to core operations.
Like total margin, Bayside’s operating margin is above the industry standard 5.8 percent versus 3.5 percent). This is good news because it shows that Bayside is earning its money the “old-fashioned way”—by having profitable operations.
Return on Assets The ratio of net income to total assets measures the return on total assets, usually just called return on assets (ROA):
Key Equation 13.3: Return on Assets
n Net income Return on assets = ------------------
Total assets Industry average = 4.8%.
$8,572 $151,278
= 0.057 = 5.7%.
Bayside’s 5.7 percent ROA (each dollar of total assets generated 5.7 cents in profit) is well above the 4.8 percent average for the hospital industry. ROA tells managers how productively, in a financial sense, a business is using its assets. The higher the ROA, the greater the net income on each dollar invested in assets and, hence, the more productive the assets. ROA measures a firm’s ability to both control expenses, as expressed by the total margin, and use its assets to generate revenue.
Return on Equity The ratio of net income to total equity (net assets) measures the return on equity (ROE):
Key Equation 13.4: Return on Equity . Net income
Return on equity = ------------------- Total equity
Industry average = 8.4%.
$8,572 $107,364
0.080 = 8.0%.
Bayside’s 8.0 percent ROE is slightly below the 8.4 percent ind average. The hospital was able to generate 8.0 cents of income on each d of equity investment, while the average hospital produced 8.4 cents ROR* especially meaningful for investor-owned businesses because owners use Rin to determine how well the business’s managers are using owner-sun r capital. In not-for-profit businesses such as Bayside, boards of trustees managers use ROE to determine how well, in financial terms, its communi supplied capital is being used.
Bayside’s 2014 margin measures and ROA were above the industry averages, yet the hospital’s ROE is below the average. As we will show in our discussion of Du Pont analysis later in the chapter, this inconsistency results from Bayside’s relatively low use of debt financing.
Liquidity Ratios One of most managers’ first concerns, and a major concern of a firm’s creditors, is the business’s liquidity. Will the business be able to meet its cash obligations as they become due? Bayside has debts totaling more than SI3 million (its current liabilities) that must be paid off within the coming year. Will the hospital be able to make these payments? A full liquidity analysis requires examination of a hospital’s cash budget, which we discuss in Chap- ter 15. However, by relating the amount of cash and other current assets to current obligations, ratio analysis provides a quick, easy-to-use, very rough measure of liquidity.
Current Ratio The current ratio is calculated by dividing current assets by current liabilities:
Key Equation 13.5: Current Ratio
Current ratio = Current assets
Current liabilities $31,280 $13,332
Industry average = 2.0.
The current ratio tells managers that the liquidation of Bayside’s cur- rent assets at book value would provide $2.3 ofcash for every $1 of current liabilities. If a business is beginning to have financial difficulty, it will start paying its accounts payable more slowly, building up short-term bank loans (notes payable), and so on. If these current liabilities increase faster than cur- rent assets, the current ratio will fall, and trouble can result. Because the cur- rent ratio is an indicator of the extent to which short-term claims are covered
bv assets that are expected to be converted to cash in the near term, it is one commonly used measure of liquidity.
Bayside’s current ratio is slightly above the average for the hospital industry. Because current assets should be converted to cash in the near future, it is highly probable that these assets could be liquidated at close to their stated values. With a current ratio of 2.3, the hospital can liquidate cur- rent assets at only 43 percent of book value and still pay off current creditors in full. (To determine the minimum proportion of current assets that must be converted to cash to meet current obligations, divide the number 1 by the current ratio. For Bayside, 1/2.3 = 0.43, or 43 percent. This proportion is confirmed by noting that 0.43 x $31,280,000 = $13,332,000, the amount of current liabilities.) Note that the industry average is not a magic number that all businesses should strive to achieve. In fact, some very well managed businesses will be above the average, while other good firms will be below it. However, if a firm’s ratios are far removed from the average, its managers should be concerned about why this difference exists. Industry averages will be discussed in detail later in the chapter.
Days-Cash-on-Hand Ratio The current ratio measures liquidity on the basis of balance sheet accounts
(in economic parlance, stocks) as opposed to income statement items (flows). However, the true measure of a business’s liquidity is whether it can meet its payments as they become due, so liquidity is more related to cash flows than it is to assets and liabilities. Thus, the days-cash-on-hand ratio is a better mea- sure of liquidity than the current ratio is:
Key Equation 13.6: Days-Cash-on-Hand Ratio
„ . , - Cash and equivalents + Short-term investments Days cash on hand =------------------1: --------------------------------------------
(Expenses - Depreciation) / 365
= $2,263 + $4,000 = $6,263 = c " ($105,576 - $4,130) / 365 " $277.93 “
Industry average = 30.6 days.
The denominator of the equation estimates average daily cash expenses by stripping out noncash expenses (depreciation) from reported total expenses. The numerator is the cash and securities available to make those cash payments. Because Bayside’s days cash on hand is lower than the industry average, its liquidity position as measured by this metric is worse than that of the average hospital.
578 Understanding Healthcare Finance Management
For Bayside, the two measures of liquidity—current ratio and cash on hand—conflict with each other. Perhaps the average hospital has ' greater proportion of cash and marketable securities in its current assets th 3
Bayside has. More analysis would be required to make a supportable iud ment concerning Bayside’s liquidity position. Remember, though, that th. cash budget is the primary tool managers use to assess liquidity.
Also keep in mind that a large days cash on hand could indicate that an organization is not effectively managing its cash resources. For example large cash and near-cash reserves might be better used by investing in longer- term securities with higher returns. On the other hand, amassing cash and short-term investments to meet an expected near-term obligation might be prudent cash management.
Debt Management (Capital Structure) Ratios The extent to which a firm uses debt financing, or financial leverage, is an important measure of financial performance for several reasons. First, by rais- ing funds through debt, owners of for-profit businesses can maintain control with a limited investment. In not-for-profit corporations, the use of debt financing enables the organization to provide more services than it could if it were solely financed with contributed and earned capital. Next, creditors look to owner-supplied funds to provide a margin of safety; if the owners have provided only a small proportion of total financing, the risks of the enterprise are borne mainly by its creditors. Finally, if the business earns more on invest- ments financed with borrowed funds than it pays in interest, the ROE capital is magnified, or leveraged up.
Two types of ratios are used to assess debt management:
1. Balance sheet data are used to determine the extent to which borrowed funds have been used to finance assets. Such ratios are called capitalization ratios.
2. Income statement data are used to determine the extent to which fixed financial charges are covered by reported profits. Such ratios are called coverage ratios.
The two sets of ratios are complementary, so most financial statement analyses examine both types.
Capitalization Ratio l: Total Debt to Total Assets (Debt Ratio) The ratio of total debt to total assets, generally called the debt ratio, measures the percentage of total funds provided by creditors:
Key Equation 13.7: Debt Ratio
Debt ratio = Total debt $43,914 Total assets $151,278
= 0.290, or 29.0%.
Industry average = 42.3%.
In this definition, debt is defined as all debt and includes current liabilities, long-term debt, and capital lease obligations—everything but equity. However, this ratio has many variations, all of which use different definitions of debt. Credi- tors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors’ losses in the event of bankruptcy and liquidation. Conversely, owners of for-profit businesses may seek high leverage either to leverage up returns or because selling new stock would mean giving up some degree of control. In not- for-profit corporations, managers may seek high leverage to offer more services.
Bayside’s debt ratio is 29.0 percent, meaning its creditors have sup- plied just under one-third of the firm’s total financing. Put another way, each dollar of assets was financed with 29 cents of debt and, consequendy, 71 cents of equity. (The equity ratio is 1 - Debt ratio, so Bayside’s equity ratio is 71.0 percent.) Because the average debt ratio in the hospital industry is more than 40 percent, Bayside uses significantly less debt than the average hospital does. The low debt ratio indicates that the hospital would find it relatively easy to borrow additional funds, presumably at favorable rates.
Capitalization Ratio 2: Debt-to-Equity Ratio Another commonly used capitalization ratio is the debt-to-equity ratio. The debt ratio and debt-to-equity ratios are transformations of each other and hence provide the same information, but with a slightly different twist:
Key Equation 13.8: Debt-to-Equity Ratio
Debt-to-equity ratio = Total debt $43,914
Total equity $107,364 = 0.409, or 40.9%.
Industry average = 73.3%.
This ratio tells analysts that Bayside’s creditors have contributed 40.9 cents for each dollar of equity capital, while the industry average is 73.3 cents per dollar. Both the debt ratio and debt-to-equity ratio increase as the proportion of a business’s use of debt financing increases, but the debt ratio
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rises linearly and approaches a limit of 100 percent, while the debt ratio rises exponentially and approaches infinity.
t0-equity
Lenders in particular prefer the debt-to-equity ratio to the debt because it tells them how much capital creditors have provided to the bi'*'* ness per dollar of equity capital. The higher this ratio, the riskier the cred' tors’ position.
Coverage Ratio i: Times-Interest-Earned Ratio The timcs-intercst-earned. (TIE) ra-tio is calculated by dividing earning! before interest and taxes (EBIT) by the interest charges. EBIT is used in the numerator because it represents the amount of income available to pay inter est expense. For a not-for-profit business, which does not pay taxes, EBIT - Net income + Interest expense. For Bayside,
Key Equation 13.9: TIE Ratio
TIE ratio = EBIT
Interest expense Industry average = 4.0.
The TIE ratio measures the number of dollars of income available to pay each dollar of interest expense. In essence, it is an indicator of the extent to which income can decline before the business’s earnings are less than its annual interest costs. If the business fails to pay interest, its creditors can bring legal action, which could result in bankruptcy.
Bayside’s interest is covered 6.6 times, so it has $6.60 of accounting income to pay each dollar of interest expense. Because the industry aver- age TIE ratio is four times, the hospital is covering its interest charges by a relatively high margin of safety. Thus, the TIE ratio reinforces the previous conclusion based on the capitalization ratios—namely, that the hospital is using a very modest amount of debt financing and hence could easily expand its use if necessary to support operations.
Coverage ratios are often better measures of a firm’s debt utilization than capitalization ratios because coverage ratios discriminate between low- interest-rate debt and high-interest-rate debt. For example, a group practice might have $10 million of 4 percent debt on its balance sheet, while another might have $10 million of 8 percent debt. If both practices have the same income and assets, both would have the same debt ratio. However, the group paying 4 percent interest would have lower interest charges and hence would be in a better financial condition than the group paying 8 percent. This dif- ference in financial condition is captured by the TIE ratio.
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Coverage Ratio 2: Cash-Flow-Coverage Ratio Although the TIE ratio is easy to calculate, it has two major deficiencies.
First, leasing has become widespread in recent years, which imposes a fixed charge similar to interest expense. Also, many debt contracts require that principal payments be made over the life of the loan, rather than only at maturity. Thus, most businesses must meet fixed financial charges other than interest payments. Second, the TIE ratio ignores the fact that accounting income, whether measured by EBIT or net income, does not indicate the actual cash flow available to meet fixed charge payments. These deficiencies are corrected in the cash-flow-coverage (CFC) ratio, which shows the amount bv which cash flow covers fixed financial requirements:
Key Equation 13.10: CFC Ratio CFC ratio - E8IT + Lease payments + Depreciation expense Interest expense + Lease payments + Debt principal / (1 - T) $10,114+ $1,368+ $4,130 $15,612 3 ?
$1,542+ $1,368+ $2,000/(l-0)_ $4,910 " Industry average = 2.3.
Note: Although not shown directly on Bayside’s financial statements, the hospital had $1,368,000 of lease payments and $2 million of debt prin- cipal repayments in 2014.
What is the purpose of the (1 - T) term applied to the debt principal? Investor-owned firms must gross up the debt principal repayments by dividing by 1 - T to recognize that principal payments are made with after-tax dol- lars. In other words, taxes must be paid on each revenue dollar before those funds are available to make principal payments. Because the numerator of the equation contains pretax dollars, for consistency the denominator must also contain pretax dollars.
Like its TIE ratio, Bayside’s CFC ratio exceeds the industry standard, which indicates that Bayside is better than the average hospital at covering its total fixed payments with cash flow. This fact should be reassuring both to creditors and management and reinforces the view that Bayside has untapped debt capacity.
Asset Management (Activity) Ratios The next group of ratios, the asset management, or activity, ratios, is designed to measure how effectively a business’s assets are being managed. These ratios help to answer whether the total amounts of each type of asset as reported on
582 Understanding Healthcare Finance Management
the balance sheet seem reasonable, too high, or too low relative to operating levels. Bayside and other hospitals must borrow or raise equir ital to acquire assets. If they have too many assets, their capital costs will ' 1 too high and their profits will be depressed. Conversely, if assets are too low they may lose profitable patient volume or not be able to offer vital services’
Fixed-Asset-Turnover Ratio
The fixed-asset-turnover ratio, also called the fixed-asset-utilization ratio measures the utilization of property and equipment. It is the ratio of total revenues to net fixed assets:
Key Equation 13.11: Fixed-Asset-Turnover Ratio . Total revenues
fixed asset turnover = ---------- -—--------- Net fixed assets
Industry average = 2.2.
$114,148 $119,998
Note that total revenues are defined here as all revenues, including nonoperating income, so Total revenues = $112,050 + $2,098 = $114,148, Also, net fixed assets are listed on the balance sheet as net property and equipment.
Bayside’s ratio of 0.95 indicates that each dollar of fixed assets gener- ated 95 cents in revenue. This value compares poorly with the industry aver- age of 2.2 times, which indicates that Bayside is not using its fixed assets as productively as the average hospital. (The lower quartile value for the indus- try is 1.8; thus, Bayside falls well into the bottom 25 percent of all hospitals in its fixed asset utilization.)
Before condemning Bayside’s management for poor performance, it should be pointed out that a major problem exists with the use of the fixed- asset-turnover ratio for comparative purposes. Recall that all assets, except cash and accounts receivable, reflect historical costs rather than current value. Inflation and depreciation have caused the values of many assets that were purchased in the past to be seriously understated. Therefore, if an old hospital that had acquired much of its property and equipment years ago is compared with a new hospital with the same physical assets, the old hospital (because of its much lower book value of assets) would report a much higher fixed-asset-turnover ratio. Such a difference is more reflective of the inability of financial statements to deal with inflation than of any inefficiency on the part of the new hospital’s managers.
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Total-Asset-Turnover Ratio The total-asset-turnover ratio measures the turnover, or utilization, of all of the firm’s assets. It is calculated by dividing total revenues by total assets:
Key Equation 13.12: Total-Asset-Turnover Ratio . Total revenues $114,148 _ Total asset turnover = ------------ - --------= „ --------= 0.75.
Total assets $ 151,278 Industry average = 0.97.
Again, note that total revenues are defined here as all revenues, including nonoperating income, so Total revenues = $112,050 + $2,098 = $114,148. The total-asset-turnover ratio tells us that each dollar of total assets generated 75 cents in total revenue. Bayside’s total-asset-turnover ratio is below the industry average but not as far below as its fixed-asset-turnover ratio. Thus, relative to the industry, the hospital is using its current assets better than it is using its fixed assets. Such judgments can be confirmed by examining Bayside’s current asset turnover. (Bayside’s 2014 current-asset- turnover ratio (Total revenues/Total current assets) is 3.6, compared to the industry average of 3.4, so the hospital is slightly above average in its utiliza- tion of current assets.
Days in Patient Accounts Receivable Days in patient accounts receivable is used to measure effectiveness in manag- ing receivables. This measure of financial performance, which is sometimes classified as a liquidity ratio rather than an asset management ratio, has many names, including days in receivables, average collection period, and days sales outstanding. It is computed by dividing net patient accounts receivable by average daily patient revenue to find the number of days it takes an organiza- tion, on average, to collect its receivables:
Key Equation 13.13: Days in Patient Accounts Receivable
n ... Net patient accounts receivable Uays in patient accounts receivable = — -----—-----------: --------------------
Net patient sendee revenue / 365
= $21,840 = $21,840 = ?7 3 .
$103,174/365 $282.67 ’ ayS’
Industry average = 64.0 days.
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In the calculation for Bayside, premium revenue has not been i because such revenue is collected before services are provided and hcnc 1
not affect receivables. Because information on credit sales generally js ° available from a business’s financial statements, the assumption that all Sjp are on credit is typically used. Although most hospital services are provide on credit because of the third-party-payer system, other healthcare businessc might have a much lower proportion of credit sales than do hospitals. As the proportion of cash sales increases, the days in accounts receivable measure loses its usefulness. Also, note that it would be better to use average receiv ables in the calculation, either by finding average monthly receivables or by adding beginning and end-of-year receivables and then dividing by two.
Bayside is not doing as well as the average hospital in collecting its receivables. The lower quartile value is 78.7 days, so a relatively large number of hospitals are doing worse. Still, as we emphasize in Chapter 15, it is important that businesses collect their receivables as soon as possible. Clearly, Bayside’s managers should strive to increase the hospital’s performance in this key area.
Average Age of Plant The average age of plant is a rough measure of the average age in years of a business’s fixed assets:
Key Equation 13.14: Average Age of Plant . , Accumulated depreciation $25,160
Average age of plant = ——--------— -------------------= - 61 Years- Depreciation expense $4,130
Industry average = 9.1.
Bayside’s physical assets are newer than those of the average hospital. Thus, the hospital offers more up-to-date facilities than average and hence will probably have lower capital expenditures in the near future. On the other hand, Bayside’s net fixed asset valuation will be relatively high, which, as pointed out earlier, biases the hospital’s fixed-asset-turnover and total-asset- turnover ratios downward. This fact raises serious questions about the validity of the turnover ratios calculated previously.
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Comparative and Trend Analyses When conducting ratio analysis, the value of a particular ratio, in the absence of other information, reveals almost nothing about financial condition. For example, if a nursing home business has a current ratio of 2.5, it is virtu- ally impossible to say whether its liquidity position condition is good or bad. Additional data are needed to interpret the value of this ratio. In the
discussion of Bayside’s ratios, the focus was on comparative analysis—that • rhe hospital’s ratios were compared to the average ratios for the industry, pother useful ratio analysis tool is trend analysis, which analyzes the trend of i single ratio over time. Trend analysis provides clues about whether a busi- ness’s financial condition is improving, holding constant, or deteriorating.
It is easy to combine comparative and trend analyses in a single graph, such as the one shown in Exhibit 13.4. Here, Bayside’s ROE (the solid line) and industry average ROE data (the dashed lines) are plotted for the past five years. The graph shows that the hospital’s ROE has been declining faster than the industry average from 2010 through 2013 but exceeded the industry average in 2014. Other ratios can be analyzed in a similar manner.
ROE
EXHIBIT 13.4 Bayside Memorial Hospital: ROE Analysis, 2010-2014
Industry
Year Bayside Lower Quartile Median Upper Quartile 2010 12.5% 2.6% 8.6% 13.3%
2011 10.0 2.5 8.6 13-3 2012 6.7 2.8 7-2 12.1
2013 2.4 4.1 7-2 12.1 2014 8.0 3-8 7-4 12.3
1. What is the purpose of ratio analysis? 2. What are two ratios that measure profitability? 3. What are two ratios that measure liquidity?
(continued)
SELF-TEST QUESTIONS
586 Understanding Healthcare Finance Management
SELF-TEST QUESTIONS
(continued from previ^^ 4. What are two ratios that measure debt management? 5. What are two ratios that measure asset management? 6. How can comparative and trend analyses be used to interpret r ’
results?
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Tying the Ratios Together: Du Pont Analysis
A complete ratio analysis provides a great deal of information about a business’! financial condition, but it does not provide an overview or tie any of the ratios together. Du Pont analysis provides an overview of a business’s financial contfci tion and helps managers and investors understand the relationships among several ratios. Essentially, Du Pont analysis—so named because managers at the Du Pont Company developed it—combines basic financial ratios in a wav that provides valuable insights into a firm’s financial condition. The analysis decom- poses ROE (which is one of the most important measures of a business’s profit- ability) into the product of three other ratios, each of which has an important economic interpretation. The result is the Du Pont equation-.
Key Equations 13.15 and 13.16: Du Pont Equation
ROE = Total margin x Total asset turnover x Equity multiplier.
ROE = Return on assets x Equity multiplier.
Note that the Du Pont equation actually has two forms. One form (Equation 13.15) has three factors on the right side of the equation, while the other recognizes that the product of the total margin and total asset turn- over is ROA. By combining these ratios, the second form (Equation 13.16) has only two factors on the right side.
The mathematical validity of the Du Pont equation can easily be seen by expressing it in ratio form:
Net income Net income Total revenues Total assets ----------------= xx ;— Total equity Total revenues Totalassets -Total equity
Net income Totalassets = --------------- x------------------- - ---7—
Total assets Totalequity
By canceling like terms in the numerator and denominator, we see that the left side of the equation is equal to the right side.
Chapter 13: Financial Condition Analysis 587
Here, we use Bayside’s 2014 data to illustrate the Du Pont equation:
$8,572 $8,572 $114,148 $151,278 $107,364 “ $114,148 X $151,278 X $107,364
8.0%= 7.5% x 0.75 x 1.4
5.6% x 1.4.
Bayside’s 2014 total margin was 7.5 percent, so the hospital made 7.5 cents profit on each dollar of total revenue. Furthermore, assets were turned over, or created revenues, 0.75 times during the year, so the hospital earned a return of 7.5% x 0.75 = 5.6% on its assets. This value for ROA is roughly the same as that calculated previously in the ratio analysis section. (Because we are carrying the calculations to only two significant places, rounding differences occur.)
If the hospital used only equity financing, its 5.6 percent ROA would equal its ROE. However, creditors supplied 29 percent of Bayside’s capital, while the equityholders (i.e., the community) supplied the rest. Because the 5.6 percent ROA belongs exclusively to the suppliers of equity capital, which makes up only 71 percent of total capital, Bayside’s ROE is higher than 5.6 percent. Specifically, ROA must be multiplied by the equity multiplier, which shows the amount of assets working for each dollar of equity' capital, to obtain the ROE of 8.0 percent. This 8.0 percent ROE can be calculated directly: ROE = Net income/Total equity = $8,572/$107,364 = 8.0%. However, the Du Pont equation shows how total margin, which measures expense control; total asset turnover, which measures asset utilization; and financial leverage, which measures debt utilization, interact to determine ROE.
Bayside’s managers use the Du Pont equation to suggest how to improve the hospital’s financial performance. To influence the profit margin (i.e., expense control), the hospital’s marketing staff can study the effects of raising charges (or lowering them to increase volume), moving into new services or markets with higher margins, entering into new contracts with managed care plans, and so on. Furthermore, management accountants can study the expense items and, while working with department heads and clini- cal staff, seek ways to reduce costs.
Regarding total asset turnover (i.e., asset utilization), Bayside’s ana- lysts, while working with both clinical and marketing staffs, can investigate ways of reducing investments in various types of assets. Finally, the hospital’s financial staff can analyze the effects of alternative financing strategies on the equity multiplier (i.e., debt utilization), seeking to hold down interest expenses and the risks of debt while still using debt to leverage up ROE.
The Du Pont equation provides a useful comparison between a busi- ness’s performance as measured by ROE and the performance of an average hospital. For example, here is the comparative analysis for 2014:
