finance management

Capital Structure Case Study

Medical Temps Inc.

Medical Temps, Inc., franchises rent-a-nurse businesses to independent operators throughout the United States. The business concept is the same as other temporary help services, such as Manpower and Kelly Temporary Services, except that Medical Temps exclusively works with registered nurses. (For more information on franchising, see the American Franchisee Association Web site at http://www.franchisee.org.)

Many healthcare providers, especially hospitals, have difficulty hiring and retaining nurses, so there is almost always a demand for nursing professionals. Hospitals are the largest employers of registered nurses, employing almost 60 percent of roughly 2.7 million working nurses. Traditionally, hospitals have been the dominant employers of nurses, but now nurses have opportunities that weren't even dreamed of a generation ago. Job opportunities include nurse practitioners, nurse anesthetists, or critical-care and neonatal specialists. Additionally, registered nurses can work at home health agencies, nursing homes, utilization review positions, physicians' offices, or outpatient surgery centers, and in a multitude of other non-hospital settings such as schools. Of all work settings, hospitals are the least desired because of the hard work, rigid work conditions, and irregular working hours. (For more information about nursing as a profession, view the American Nurses Association Web site at http://www.nursingworld.org.)

Providers are very reluctant to build a large base of fixed costs, so any staffing requirements that may not be permanent in nature are often filled by temporary workers. Also, when vacancies occur among permanent workers, providers often need temporary nurses to carry the load until vacancies are closed.

Although nursing salaries have increased over the past ten years (see Table 1), real wages have barely kept up with inflation. Additionally, a large number of nurses have quit the profession for a variety of reasons, including family responsibilities. Many of these nurses are willing to work occasionally but not on a permanent basis.

Typically, nurses who want to work on a selective basis have spouses who provide health insurance for the family. Also, these nurses do not require extensive fringe benefits such as pension plans or paid vacations, and because they are part-time workers, they are not eligible for unemployment insurance or workers' compensation. Therefore, if the average fringe-benefit package paid for permanent nurses is, say, 25 percent of their salary, a temporary services company could offer a salary to its nurses 5 percent higher than can providers; could rent the nurses out at 5 percent less than it costs providers to hire permanent nurses, including all fringe benefits; and could pocket what remains of the 15 percent spread after administrative costs are paid. Note, however, that the actual rates charged by Medical Temp's franchisees are related more to local supply and demand conditions than to costs.

Franchisees buy the exclusive right to use the Medical Temps name within a specified territory from the franchisor. Additionally, franchisees receive marketing and management support from Medical Temps as well as the right to lease computers and other office equipment under relatively favorable terms. Finally, franchisees can purchase expendable office supplies directly from Medical Temps at substantial savings on retail prices.

To start operations, a franchisee recruits a pool of nurses from the local labor market. When a client needs a temporary nurse, the local manager matches the client's specific needs with a qualified nurse from the pool. The bill for services is sent to the client by the franchisee based on the number of hours—verified by a timecard—that the nurse works for the client. The client has no responsibility for the nurse's salary or fringe benefits; this is all handled by the Medical Temps franchisee.

Tiffany Radcliff, a registered nurse from Albuquerque who left the profession to get an MBA from the University of New Mexico, founded Medical Temps in 1985. The firm grew rapidly from its base in Albuquerque, first, by expanding operations into different cities across the Southwest and next by franchising in other parts of the country. Tiffany is a devout believer in the virtues of equity financing. Although the firm has issued debt periodically, especially to finance company-owned business expansion, Tiffany always uses the firm's free cash flow to retire the debt as soon as possible. Recent growth has involved franchising, in which the franchisee puts up the required capital, and therefore there has been no need for outside capital for several years.

Tiffany believes that her firm's high-growth days are over. First, numerous companies that offer competing services have appeared on the scene. Second, the number of hospitals, which are her primary clients, has actually declined over the years since she founded the firm, consequently a meaningful increase in hospital beds is unlikely in the near future. Third, some hospitals are creating flexible staffing pools for nurses which, for all practical purposes, are in-house temporary work agencies. Finally, many large employers of nurses are recruiting internationally, which lessens the demand for temporary workers. Therefore, Tiffany expects the firm's earnings before interest and taxes (EBIT) to grow relatively slowly in the future.

Medical Temps has 10 million shares of common stock outstanding, which are traded in the over-the-counter market. The current share price is $1.20, so the total market value of the firm's equity is $12 million. The book value of equity is also $12 million, so the stock now sells at its book value. The firm's federal-plus-state tax rate is 40 percent. Tiffany owns 20 percent of the outstanding stock, and others in the management group own an additional 10 percent.

Tiffany's financial manager, Paul Duncan, has been preaching for years that Medical Temps should use debt in its capital structure. "After all," says Paul, "everybody else uses debt, and some of our competitors use over 50 percent debt financing. Also, an under-leveraged company is exposed to a hostile takeover because raiders can use the firm's excess debt capacity to finance the bid."

If the firm were to recapitalize, the borrowed funds would be used to repurchase stock in the open market, as the funds are not needed to support growth. Tiffany's reaction to Paul's prodding is cautious, but she is willing to give Paul the chance to prove his point. Paul has worked with Tiffany for the past six years and knows that the only way he can convince her to use debt financing is to conduct a comprehensive analysis.

To begin, Paul arranges for a joint meeting with an investment banker who specializes in corporate financing for service companies. After several hours, the pair agrees on the estimates for the relationships between the use of debt financing and Medical Temps' capital costs shown in Table 2. Additionally, Paul obtains industry capitalization data for companies that franchise professional services along with the matching debt ratings on the basis of rough guidance provided by Standard & Poor's Ratings Services. These data are in Table 3.

On the basis of previous conversations, Paul knows that Tiffany has two major concerns regarding the use of debt financing. First, she is concerned about the impact of debt financing on the firm's reported profitability; that is, the impact of debt financing on net income and return on equity (ROE) as reported in the firm's financial statements. Further, any risk implications to stockholders must be identified. To help with this, Paul plans to construct partial income statements (beginning with EBIT) for four levels of debt as measured by the book value total debt to total assets ratio: zero, 25 percent, 50 percent, and 75 percent. For this analysis, which will not be used to make the actual capital structure decision, Paul intends to use a cost of debt of 10 percent regardless of the amount of debt financing used.

However, in addition to accounting effects, Tiffany is obviously concerned about the potential impact of debt financing on the firm's shareholders: specifically, what impact debt financing will have on stock price. To address this issue, Paul is aware of a technique that can be used to value zero-growth firms at different debt levels. Clearly, the results of this analysis do not apply exactly to Medical Temps, which is expected to experience slow growth, as opposed to zero growth, over the coming years. Paul is also concerned about potential changes in the healthcare industry and how they might affect the basic business risk of Medical Temps. Table 4 contains leverage to cost estimates at alternative business risk levels.

Equations used in the Analysis

E = [EBIT – (R(Rd) x D)](1 – T)/R(Re) V = E + D P = (V – D0)/n0 n1 = n0 – D/P

where

E – Market value of equity EBIT – Earnings before interests and taxes R(Rd) – Cost of debt D – Market (and book) value of debt D, – Market value of old debt T – Tax rate R(Re) – Cost of equity V – Total market value P – Stock price after recapitalization n0 – Number of shares before recapitalization Number of shares after recapitalization

Finally, because the capital structure decision is heavily influenced by a host of qualitative factors as well as the actions of other businesses in the industry, Paul uncovers the additional industry data, shown in Note 1. Assume you are Paul’s assistant and your task is to aid him and Tiffany with the analysis and debt financing decisions.

Optional information: (Address this issue only if you are familiar with the following capital structure models.) Paul knows that Tiffany is familiar with capital structure theory and will assess the value of the firm according to the Modigliani-Miller (MM) with the corporate taxes model and the Miller model. It will be necessary to conduct a tutorial on the issues involved because most of the other board members are not very familiar with capital structure decisions, including the difference between business and financial risk, the relationship between capital structure and earnings per share (EPS), and the additional qualitative factors that influence the decision. To ease comparisons, assume that the value of an unleveraged firm is $12 million in both models. Also, assume that the personal tax rates are 25 percent on stock income and 30 percent on debt income.

Table 1: Medical Temps, Inc.: Average Annual Income of Registered Nurses
Position	Annual Income
Acute care	45,000
Ambulatory care	44,000
Nurse Manager	65,000
Nurse practitioner	62,000
Operating room	45,000
Physician's office	36,500
National average	45,000
Source: Allied Physicians Web site, http://www.allied-physicians.com

Table 2: Medical Temps Inc.: Relationships between the Level of Debt Financing and Capital Costs
Amount Borrowed (dollars)	Cost of Debt (percentage)	Cost of Equity (percentage)
0	—	15.0
2,500,000	10.0	15.5
5,000,000	11.0	16.5
7,500,000	13.0	18.0
10,000,000	16.0	20.0
12,500,000	20.0	25.0

Table 3: Medical Temps Inc.: Industry Average Data and Matching Debt Ratings
Percentile	Market Value Debt Ratio (percentage)	Debt Rating
10th	10	AAA
25th	25	AA
40th	35	A
Median	50	BBB
60th	65	BB
75th	75	B
90th	82	C
Note: The debt ratio is defined as Total Debt/Total Assets.

Although Medical Temps’ EBIT is expensive—expected to be $3 million in 2007—there is some uncertainty in the estimate, as indicated by the following probability distribution:

Probability	EBIT
0.25	2,500,000
0.50	3,000,000
0.25	3,500,000

Table 4: Medical Temps Inc.: Level of Debt and Cost Estimates at Different Business Risk Levels
Amount Borrowed	Significant Increase in Business Risk	Significant Decrease in Business Risk
	Cost of Debt	Cost of Equity	Cost of Debt	Cost of Equity
0	—	16.0%	—	14.0%
2,500,000	11.0%	17.0	9.0%	14.3
5,000,000	13.0	19.0	9.5	15.0
7,500,000	16.0	22.0	10.5	16.0
10,000,000	20.0	26.0	12.5	17.5
12,500,000	25.0	31.0	15.5	20.0

Note 1: Medical Temps Inc.: Additional Data

The average health franchise business has a times interest earned (TIE) ratio of 4.0. Medical Temps, Inc. has current cash and marketable securities balance of $500,000. The average healthcare franchise business has cash and marketable securities on hand that is equal to 70 percent of its annual interest payment.