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Risk and Return 9

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Learning Outcomes By the end of this chapter, you will be able to:

• Explain the importance of uncertainty and risk in the determination of expected returns

• Calculate stand-alone risk for projects or organizations

• Understand financial risk and use the capital asset pricing model to estimate the cost of equity capital

• Calculate the weighted average cost of capital

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Section 9.1Risk and Return

Introduction Over the past four years financial assets at Bixby Hospital have increased by $26.5 million due to returns in the stock market on their portfolio of investments. The average annual return on investments has been 10.6% and very chaotic. In 2009 returns were 0.7%, in 2010 they were 36.8%, in 2011 they were 27.4%, and in 2012 they were 12.1%. The standard deviation of investment returns over the past four years has been 19.1%. If Bixby had held its portfolio of investments solely in federal government bonds, it would have earned an average annual return of 1.0% with a standard deviation of 1.0% (U.S. Department of Treasury, 2014). Bixby earned a higher average annual return by accepting a higher level of risk, as measured by the standard deviation of returns.

Among the most central concepts in finance is the relationship between risk and return. As will be discussed in this chapter, earning a higher level of return, as Bixby did by investing in the stock market rather than government bonds, involves taking more risk. The material presented in this chapter is a bit more conceptually challenging than the material in the other chapters of this book. And yet, students who master the material in this chapter will have a greater appreciation of financial management and be prepared for more advanced studies.

9.1 Risk and Return As stated throughout this book, financial management involves trade-offs. Profitability of healthcare organizations, and the investments they make, involves trade-offs between risk and return. Quite simply, to earn higher expected profits (returns), organizations must take more risks. Higher expected risks on investments in financial assets are quite systematically linked to higher returns (Conrad, Dittmar, & Ghysels, 2013). To persuade investors to pur- chase the debt (loans and bonds) in high-risk firms, those firms issuing debt must promise a higher expected return, which comes in the form of higher interest rates. Similarly, to per- suade investors to purchase stock (equity) in high-risk firms, those firms issuing stock must promise a higher expected return, which comes in the form of profits (net income). Since prof- its are more difficult to promise than interest payments, the expected returns on stocks must be substantially more than the expected returns on bonds for the same level of business risk.

The term returns appears six times in the preceding paragraph. Returns to debt holders, in the form of interest payments, are costs to the organization. Returns to the owners of the orga- nization are the profits earned after interest expenses and taxes. For the owners of investor- owned firms, returns are reflected in dividends or stock price appreciation. For the owners of not-for-profit organizations, returns are somewhat less clear. Profits enable the not-for-profit organization to continue to exist and provide funds for future charitable activities. Owners of not-for-profit organizations may want something different than profits. The community that owns a not-for-profit healthcare organization may want it to provide effective, high-quality services in an efficient manner and to provide charity care and other services. The issue of returns to not-for-profit organizations will be considered more fully in Chapter 10.

The term risk also appears six times in the preceding paragraph, and not by coincidence. Three types of risk are considered in this chapter: firm-specific risk, market risk, and portfolio risk. Firm-specific risk is the risk associated with the operations and management

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Section 9.1Risk and Return

of one particular organization. Market risk is the risk associated with the industry that a firm is in and the overall economy. Portfolio risk is the risk associated with a number of invest- ments, potentially several firms, in several industries, in several economies.

This chapter more fully develops the definition of risk and presents tools required for mea- suring and adjusting analyses when risk is involved. The end product of this chapter is a way to define the returns associated with risks for use in long-term financial decision making. Tools and measures discussed will rely upon information provided on financial statements as well as information about the debt and equity markets more generally.

Uncertainty and Risk Uncertainty is defined as not having perfect knowledge of future outcomes. In the business of providing healthcare services, there are many sources of uncertainty. It is not known how many people will become ill or injured, or, more generally, what anyone’s health status will be on any given day. For persons who suffer ill health, it is not known how, where, or if they will seek medical services for treatment. And if persons suffering ill health seek medical services at a particular organization, it is not known what services they will be provided or how they will pay for these services. All of the uncertainty with regards to patients’ health status and care-seeking behavior translates to uncertainty for healthcare providers. It is unknown how many healthcare providers and other employees should be at work on a given day. And it is unknown what supplies and other resources they will require to perform well on the job. All of the unknown elements result in a high level of uncertainty for man- agers of healthcare organizations.

Uncertainty translates directly into risk. From a finance perspective, risk is the monetary impact of uncertainty. An organization that does not know specifically how many patients will visit the emergency department in a given evening displays uncertainty. If there will be the same number of nurses and other personnel staffing the emergency department, irrespective of the number of patients, then there is no risk in terms of costs. All risk is associated with uncertainty. Not all uncertainty is associated with risk.

Risk is measured by the variation in possible outcomes. From the financial perspective of a healthcare organization, risk is measured by the variation in cost, revenues, and profits (returns). A common measure of profit risk is the standard deviation in returns, written as the following equation:

Standard deviation 1s2 5 Å a N

i 5 1

1Pi 3 1ri 2 E 3r 4 2 2 2

where the Greek symbol sigma (s) is conventionally used to represent the standard deviation. The summation function (∑) is taken from the first observation (1) until the last time period (N ). Since the calculation for the standard deviation may be among several observations of

From the Front Lines The department managers and finance department are always in a state of ten- sion with one another. It is hard to main- tain reserve capacity when finances are tight, and unfortunately, we regularly exceed our target ratio of personnel per occupied bed, which occurs when things are slow and we can least afford it. Source: Health system chief operating officer.

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Section 9.1Risk and Return

returns during the same period, as well as among several observations over time, the sub- script i represents the observation and N indicates the total number of observations. New terminology includes the probability (Pi ) of a return on a specific observation (ri ) and the expected return among all observations (E[r]). When the probabilities and all expected returns are equal, Pi can be omitted. The standard deviation is calculated as the square root of the sum of the differences between actual returns and the expected return. The average value among available observations of returns is often used as the measure of the expected return.

If the distribution of the set of possible returns follows a normal distribution, then 68% of the observations will be within one standard deviation, plus or minus, of the average return, and 95% of the observations will be within two standard deviations, plus or minus, of the aver- age return. Consider the normal distribution of returns depicted in Figure 9.1. The expected return is 9% with a standard deviation of 3%. Two thirds of all returns occur within the range of 6% to 12%. Ninety-five percent of all returns occur within the range of 3% to 15%.

Figure 9.1: Normal distribution of returns

For any organization, the risk of its returns may be measured by the standard deviation of returns in prior years, with the expected return being the average return over the same time period. The investment returns of Bixby Hospital and the Standard & Poor’s 500 Index, an index of the returns of the 500 largest investor-owned corporations in the United States, are presented in Figure 9.2. Note that these are not the profits of Bixby Hospital (the total returns to its owners), only the returns that the hospital has earned on its financial investments. Bixby experienced both a lower average return (10.6% versus 14.9%) and a higher risk (standard deviation of 19.1% versus 10.0%) than the Standard & Poor’s 500 index.

0

–3 211812 1593 60

0.14

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Section 9.1Risk and Return

Figure 9.2: Normal distribution of returns for Bixby Hospital and the Standard & Poor’s 500 index, 200922012

Source: Author’s calculations and Standard & Poor’s (http://us.spindices.com/indices/equity/sp-500).

Calculation of Averages and Standard Deviations The calculation of averages and standard deviations of observations can be performed by hand or with a calculator. To ease the task when there are a number of analyses that must be performed, or when there are many observations, electronic spreadsheets may be used instead. Many popular calculators have a function key for square root, and even for average and standard deviation. Electronic spreadsheets permit calculations based on the use of pre- specified statistical functions. A calculation of the average return and standard deviation of returns for Bixby Hospital is presented in Exhibit 9.1.

Exhibit 9.1 Spreadsheet calculations of average and standard deviation of returns, Bixby Hospital

A B C D E

1 Year Assets Limited

as to Use Investment

Returns Percentage

Return 2 2009 $30,429,437 $221,544 0.7% =(C2/B2) 3 2010 $57,263,543 $21,075,240 36.8% =(C3/B3) 4 2011 $63,042,673 ($4,655,574) –7.4% =(C4/B4) 5 2010 $81,577,433 $9,900,226 12.1% =(C5/B5) 6 Average 10.6% =average(D2:D5)

7 Standard deviation 19.2% =stdev(D2:D5)

8 Source: Author’s calculations.

0

–100 8040 6020–60 –20–40 0–80

0.025

0.020

0.010

0.015

0.005

P ro

b a

b il

it y

D e

n s

it y

Bixby Hospital Standard & Poor’s 500 Index

0

–100 80100 10040 6020–40 0–80 –20–60

0.045

0.040

0.030

0.020

0.035

0.025

0.005

0.015

0.010

P ro

b a

b il

it y

D e

n s

it y

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Section 9.2Stand-Alone Risk

Analyze This The operating margins at Bixby Hospital for 200822010 are presented here. What is the aver- age operating margin over this time period, and what is the standard deviation of the operating margin?

2008 2009 2010 2011 2012 17.8% 12.5% 5.2% 9.4% 7.8%

For Review: 1. What is the expected relationship between risk and expected returns from a finance

perspective? Risks and returns are expected to have a positive relationship. If one is asked to take on more risk, there should be a higher expected return to make the investment worthwhile.

2. Why is the standard deviation a measure of risk? Risk is measured by the variation in possible outcomes, and the standard deviation is a measure of variation.

9.2 Stand-Alone Risk Every business organization is associated with some level of risk. The term for the risk associ- ated with a single organization, or a single project within an organization, is stand-alone risk. Stand-alone risk is also called business risk when referring to profitability. The stand-alone risk for an organization can be separated into the risks faced by the two sources of financial support: debt and equity. The stand-alone risk for debt holders is the likelihood that the orga- nization will not earn enough revenue to cover the interest expense and ultimately repay the amount borrowed. The stand-alone risk for equity holders, or business risk, is the standard deviation of net income or stock returns.

Risk for Debt Holders For debt holders, risk is taken into consideration in the setting of interest rates. Organiza- tions with higher expected levels of risk face higher interest rates on debt than organizations with lower expected levels of debt. For short-term loans, interest rates are charged by banks. For long-term debt, interest rates are informed by credit ratings provided by one or more agencies. As presented in Figure 9.3, credit ratings are typically higher for hospitals that have higher operating margins. Operating margins are one of many considerations in the determi- nation of credit ratings.

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Section 9.2Stand-Alone Risk

Figure 9.3: Stand-alone hospital credit ratings and operating margins, 2012

Source: Author’s calculations based on data contained in: Standard & Poor’s. (2013). U.S. Not-for-Profit Health Care Stand-Alone Ratios: Operating Pressures Led to Mixed Results in 2012. New York, NY: Standard & Poor’s (http://www.standardandpoors.com).

Debt holders for UnitedHealth Group (UNH on the New York Stock Exchange), one of the larg- est managed healthcare organizations in the United States with over $110 billion in revenues in 2012, are informed of its credit rating by four agencies: Standard & Poor’s (A3 negative), Moody’s (A stable), Fitch (A2 stable), and A.M. Best (BBB1 stable) (UnitedHealth Group, 2012). As displayed in Exhibit 9.2, the interest rates on large amounts of long-term debt are 5.80% to 6.88%. Financial statements and other required filings to the U.S. Securities and Exchange Commission, the source of information on the cost of debt to investor-owned orga- nizations, are available for free on the SEC website (http://www.SEC.gov).

Exhibit 9.2 UnitedHealth Group, senior unsecured notes due 203622038 Due Date Amount Interest Rate March 2036 $850,000,000 5.80% June 2037 $500,000,000 6.50% November 2037 $650,000,000 6.63% February 2038 $1,100,000,000 6.88% Source: Author’s calculations, based on UnitedHealth Group, 2012.

Credit Rating

0%

1%

AA–AA BBBBBB+A A– LowerBBB–A+

6%

5%

4%

3%

2%O p

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Section 9.2Stand-Alone Risk

To provide debt holders with some protection against further risk, debt agreements often include debt covenants. Debt covenants dictate operating or financial conditions that the organization must meet or face immediate debt repayment or other penalties. For United- Health Group, one covenant is to maintain a debt ratio (liabilities divided by total assets) of not more than 50% (UnitedHealth Group, 2012). The debt covenant involving the debt ratio limits how much UnitedHealth Group can borrow and, therefore, limits the risk that there will not be sufficient funds available to pay the interest owed to current debt holders.

Risk for Equity Holders Equity holders do not have the same rating guidance as debt holders or protections like debt covenants. Equity holders own the net income of the organization, after debt and taxes. The true business risks for an organization, the risks associated with profitability, are borne by the equity holders. For investor-owned organizations, presentations of risks are required by the SEC. For example, UnitedHealth Group lists a number of risks that could materially and adversely affect the results of their operations, their financial position, and cash flows. These risks include

• Failure to effectively manage medical costs • New laws or regulations • Government healthcare program funding and enrollment • Failure to compete effectively to maintain or increase market share, including main-

taining or increasing enrollments in businesses providing health benefits (UnitedHealth Group, 2012)

Reflecting the relative risk between debt and equity, returns on equity are expected to exceed returns on debt. For UnitedHealth Group, as well as firms generally (as measured by a com- posite of the 50 largest firms in the United States and the S&P 500), equity returns are much more volatile and, on average, higher than debt returns. As displayed in Exhibit 9.3, at the same time that debt for UnitedHealth Group has been issued at 5.80% to 6.88%, their equity returns (as measured by dividends and stock price appreciation) have varied from 8.6% to 42.2%.

Exhibit 9.3 UnitedHealth Group, Fortune 50, and S&P 500 returns, 200922012 2009 2010 2011 2012

UnitedHealth Group 14.8% 19.9% 42.2% 8.6% Fortune 50 11.8% 18.2% 0.0% 18.5% S&P 500 Index 26.5% 15.1% 2.1% 16.0% Source: UnitedHealth Group, 2012.

Stand-alone risks exist for both the debt and equity of every organization. The essence of the stand-alone risk for debt holders is the potential that the organization will be unable to make its required debt payments. The essence of the stand-alone risk for equity holders is the vari- ability in the net income that remains after debt payments and taxes. If there is a risk of being unable to make debt payments, then clearly there is a risk that net income will be very low or negative, which is the connection between risk for debt holders and risk for equity holders.

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Section 9.3Financial Risk

For Review: 1. Why are equity risks greater than debt risks?

Equity risks are associated with overall organization profitability. Debt risks are associated with the ability to make debt payments. The variation in overall organiza- tion profitability are generally greater than whether or not organizations can pay for their debt. Further debt payments are an expense and profits are the amounts left over after all expenses have been paid.

2. Can you think of any other equity risks for a healthcare organization, beyond those listed for UnitedHealth Group? There are many possible equity risks. Some risks include litigation actions, which could damage reputation and result in substantial penalties; losses in investment portfolios; failure to properly maintain the integrity or availability of data or to stra- tegically implement new or upgrade or consolidate existing information systems; or technology products that do not operate as intended.

9.3 Financial Risk In addition to the business risk associated with the profitability of the operations of an organiza- tion, another risk incurred by organizations when debt is issued is financial risk. Financial risk has two components: debt requirements and equity return enhancement. This risk is the cost of the uncertainty associated with revenues that may not cover all expenses, especially interest and principal payment on debt. Organizations without debt that face shortfalls in net income suffer from the reduction in net assets. Owners of the organization, or the community-at-large in the case of a not-for-profit organization, may seek changes in management or activities to achieve positive levels of net income in the future. Organizations with debt that face shortfalls in net income may additionally suffer from the actions of debt holders. Debt requirements in the form of covenants related to net income may involve additional scrutiny from debt holders or other costs. Further, under conditions of serious net income shortfalls and the ability to pay interest and principal, the viability of the organization may be at stake.

The second, and perhaps more important, aspect of financial risk is the enhancing effect that debt has upon equity returns. The use of debt to facilitate the purchase of assets serves as leverage on the equity (net assets for not-for-profit organizations) of the healthcare organi- zation. With a limited amount of equity, the organization can obtain more assets and provide more services when debt is used. Of course, the use of debt has a cost. Organizations must pay interest for the use of funds provided by others as well as pay back the debt at some point in time. A subtle though important financial implication of leverage is that the cost of debt is fixed for any time period (interest expense), and the net income associated with services provided by the assets purchased using debt are variable. If the percentage rate of return on services (net income) is greater than the interest rate paid on debt, leverage will increase the percentage rate of return to the equity holders of the organization.

The effect of financial risk is subtle, so an example is needed to explain it fully. Consider the financial statements of Bixby Hospital, which are presented in an abbreviated manner in Exhibit 9.4. In 2012 the balance sheet of Bixby included $49.6 million in total liabilities (debt) and $132.2 million in net assets. The debt ratio, or the ratio of total liabilities to total assets, is 27.3%.

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Section 9.3Financial Risk

Debt ratio 5 Total liabilities

Total assets 3 100%

5 $49,611,000

$181,836,031 3 100%

5 27.3%

Another measure of profitability, beyond the four presented in Chapter 3, is the return on net assets (also called the return on equity), as defined by the following equation:

Return on net assets 5 Net income Net assets

3 100%

5 $10,894,838

$132,225,031 3 100%

5 8.2%

For Bixby Hospital in 2012, the return on net assets is 8.2%. This is larger than the cost of debt, which is around 3%. Therefore, at Bixby Hospital, we expect leverage to increase the return on net assets.

Exhibit 9.4 Financial statements and leverage, Bixby Hospital, 2012 Balance Sheet 2012 Alternative 2012 Total assets $181,836,031 $181,836,031 Total liabilities $49,611,000 $149,611,000 Net assets $132,225,031 $32,225,031 Total liabilities and net assets $181,836,031 $181,836,031 Income Statement Net patient revenues $110,029,830 $110,029,830 Interest expense $840,479 $4,488,330 Total operating expense $101,395,296 $105,882,786 Operating Income $8,634,534 $4,147,044 Miscellaneous nonpatient revenue $2,260,304 $2,260,305 Net Income or (Loss) $10,894,838 $6,407,349 Debt ratio (Total liabilities/Total assets) 27.3% 82.3% Return on net assets 8.2% 19.9% Source: Author’s calculations.

The effects of leverage on the return on net assets is demonstrated by the suggested alterna- tive financial statement for 2012, also presented in Exhibit 9.4. For purposes of discussion, suppose that there were $100 million more in long-term debt at Bixby, and correspondingly $100 million less in net assets. That is, suppose that the balance sheet of Bixby included $149,611,000 in total liabilities and $32,225,031 in net assets. The resulting debt ratio is 82.3%. Also note that the resulting interest expense is much higher, and therefore operating income and net income are lower. Now here is the important result, the return on net assets is

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Section 9.3Financial Risk

19.9%. As long as the initial return on net assets is greater than the interest rate, higher debt ratios will result in higher resulting returns on net assets.

Debt ratio 5 Total liabilities

Total assets 3 100%

5 $149,611,000 $181,836,031

3 100%

5 82.3%

Return on net assets 5 Net income Net assets

3 100%

5 $6,407,349

$32,225,031 3 100%

5 19.9%

With those results on the effects of leverage on returns on net assets, why don’t organiza- tions borrow as much as possible? Why aren’t debt ratios close to 100%? Again, the use of debt involves financial risk, which has two components: debt repayment requirements and equity return enhancement. With higher levels of debt, the required payments associated with debt (interest and principal payments) are higher. With higher required payments, there is a greater likelihood of experiencing revenue shortfalls that impact debt holders. For this reason, organizations with higher debt ratios, on average, have lower credit ratings and pay higher interest rates. At very high levels of debt, interest rates become very high. Further, as a protection for their risks, debt holders may place covenants on organizations that limit the use of debt. The debt ratio, the long-term debt to capitalization ratio, or the debt-service cov- erage ratio may be placed in a covenant.

The effect of leverage on equity return enhancement is the other source of financial risk that limits the amount of debt that organizations will use to support the balance sheet. Just as leverage increases the return on net assets when net income is high, it decreases the return on net assets when net income is low. Suppose for Bixby Hospital that net patient revenues had been $10 million lower in 2012, and that all other factors had remained the same. At their existing debt ratio of 27.3%, the result of the lower level of net patient revenues would have been net income of only $894,838 ($10,894,838 2 $10,000,000) and a return on equity of only 0.7%.

Return on net assets 5 Net income Net assets

3 100%

5 $894,838

$132,225,031 3 100%

5 0.7%

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Section 9.3Financial Risk

Under the alternative 2012 financial statements, with a debt ratio at the higher 82.3% level, the lower net patient services revenue would be associated with a net loss of $3,592,651 ($6,407,349 2 $10,000,000) and a return on equity of 211.1%.

Return on net assets 5 Net income Net assets

3 100%

5 2$3,592,651 $32,225,031

3 100%

5 211.1%

Leverage works both ways; it magnifies returns when profits are positive and magnifies losses when profits are negative.

Analyze This If miscellaneous nonpatient revenue at Bixby Hospital had been zero in 2012, what would have been the return on net assets under the actual results and under the alternative provided in Exhibit 9.4?

Portfolio Risk With the potentially substantial business risk inherent to every organization, as well as the added financial risk associated in organizations that use debt, investors may seek ways in which to reduce the risk of their holdings by spreading their money across many organi- zations. The general term for the process of spreading investments across different assets is diversification. The general term for the group of assets pooled together for investment purposes is a portfolio. The first finance principle associated with diversification is that the return on a portfolio is merely the weighted average of the returns on the individual invest- ments within the portfolio. Having a portfolio of assets, by itself, rather than any single invest- ment, does not change expected returns. For an investor who owns many stocks, the expected return on the portfolio is the weighted average of the returns on the individual stocks. For a healthcare organization that owns many separate businesses, the expected return (net income) is the sum of the expected returns from each business.

An important and intuitive second finance principle associated with diversification is that the risk of a portfolio of assets is generally less than the risk associated with a single asset. As a demonstration of the principles of diversification, consider investments in some of the largest U.S. healthcare organizations. As shown in Figure 9.4, the risks and returns are highly variable for five large healthcare insurance and managed care companies (UnitedHealth Group, Well- Point, Humana, Aetna, and Cigna) and five large healthcare facility companies (Community Health Systems, Tenet Healthcare, DaVita HealthCare Partners, Universal Health Services, and Health Management Associates).

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Section 9.3Financial Risk

Figure 9.4: Risk and returns for large healthcare organizations, 201022012

Source: Author’s calculation, based on individual company Annual Reports (Form 10-K) (http://www.SEC.gov).

The average among the average returns for each company displayed in Figure 9.4 is 16.5% per year. The range of average returns is 3.1% to 24.4%. A portfolio that contains equal dol- lars invested in each company (that is, the portfolio value is 10% for each of the 10 compa- nies) would yield a return of 16.5%.

The standard deviation of the returns for these 10 companies ranges from 13.2% to 65.6%. The average standard deviation of the returns among these companies is 28.8%. The inter- esting aspect of risks is what happens with a portfolio of assets. As predicted by the finance principle associated with diversification, the risk of the portfolio is less than the average risk among assets within the portfolio. In this case, the standard deviation of returns for each company is greater than the 8.9% risk associated with the portfolio. Holding a portfolio of assets, risk is reduced.

The degree to which risk is reduced with a portfolio is dependent upon the relationships among the returns on the assets of the individual investments. If the risks and returns among assets in a portfolio are very similar (very high correlation with one another), the risk reduc- tion is minimal. If the risks and returns among assets in a portfolio are very different (very low correlation with one another), the risk reduction is substantial. For investors, finding the portfolio of assets that achieves desired rates of returns, with acceptable risks, can be a con- tinuous process of searching and adjusting holdings.

Average Returns

0%

10%

5%0%

Community Health Systems

Tenet Healthcare

Universal Health Services

DaVita HealthCare Partners

Health Management Associates

Wellpoint

Aetna

Cigna

Total Portfolio

UnitedHealth Group

Humana

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Section 9.3Financial Risk

Just as a portfolio of assets can reduce risk for an investor, a portfolio of services within a healthcare organization can reduce risks as compared to having only one service. There is an ongoing debate within many companies about the extent to which diversification should occur. On the one hand, the finance principle of diversification suggests greater diversifica- tion to reduce risks. Having a broad portfolio of services will reduce risk and perhaps help to assure the viability of an organization. If the profitability of one particular service should suffer, the organization can continue operations.

On the other hand, diversification takes the time and attention of senior managers and may detract the focus from the most important, and perhaps narrowly defined, services. Health- care organizations that focus their time and attention on a limited number of services may be able to achieve great expertise and efficiency in the delivery of those services at the expense of risk. The debate about the optimal degree of diversification is a good one to have within a healthcare organization.

Cost of Equity: The Capital Asset Pricing Model For the use of debt, organizations can rely upon banks and markets, as influenced by credit ratings, to establish the cost of debt. To determine the cost of equity to an organization, there are no simple ways of approaching investors for capital investments, as we can do with banks for loans. Instead, organizations may propose offers of ownership in an organization to indi- vidual investors or the open market for investors and see what prices they are willing and able to pay for ownership shares. This is, in fact, how values of ownership of equity are estab- lished—through exchanges in the market. The cost of equity to the firm is therefore set by the views of investors on the risk of the firm and the expected returns. As with all investments, higher risks must be associated with higher expected returns, or there will not be investors.

The challenge to organizations seeking to estimate the cost of capital for planning and bud- geting purposes, without engaging in market exchanges, is where they can find information on the relationship between risk and returns. In the modern practice of corporate finance, there is a model that can be used to estimate the relationship between risk and returns called the capital asset pricing model (CAPM). Developed by William Sharpe (Sharpe, 1964) and refined and tested by hundreds of economists over the years, CAPM provides a reasonable estimate of the expected returns for varying levels of risks and other market conditions.

The first key idea behind the CAPM is that investors may allocate their investments between risk-free assets, like U.S. Treasury bills, and risky assets, like equity in a particular company. The second key idea is that investors should be reasonably consistent and efficient in their use of information about interest rates, the average return on investments in the market as a whole, and the relative risk involved with a particular investment. The third key idea behind the CAPM is investors generally hold a portfolio of investments, with an investment in one company being only a part of their overall holdings.

The basic equation for the CAPM is written as

E[ri] 5 rf 1 bi 3 (E[rM]) 2 rf )

where E[ri] is the expected return on one particular investment (indicated by the subscript i ). The risk-free rate of return is represented as rf , and the expected rate of return for the market as a whole is represented as E[rM]. The last term in this equation, bi (pronounced

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Section 9.3Financial Risk

beta), indicates the relative riskiness of one particular investment as compared to the riski- ness of the market as a whole. The term in parentheses (E[rM]) 2 rf ), the difference between the expected return for the market as a whole and the risk-free rate of return, is referred to as the market risk premium. The market risk premium indicates, on average, how much higher returns on equity investments are compared to risk-free rates.

For the risk-free rate, a common data source is the U.S. Treasury. On October 30, 2013, the rate of return on U.S. Treasury bills (90 days) was 0.035%, which is zero for all practical pur- poses, as it has been since 2009. For an investor considering a long-term investment, a longer term risk-free rate would be appropriate. The current rate of return on U.S. Treasury bonds (30 years) is 3.64%. Taking a longer-term view, the rate of return on U.S. Treasury bonds is usually around 5%. As presented in Figure 9.5, interest rates are normally higher as the time period for investment gets longer. The slope of the line for interest rates over time is called the yield curve.

Figure 9.5: Risk-free rate yield curve, October 30, 2013

Source: Daily Treasury yield curve rates, http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/ TextView.aspx?data=yield.

For the market rate of return, a broad portfolio of investments is generally selected, such as the Standard & Poor’s 500 Index. In Exhibit 9.3, the average annual rate of return on the S&P 500 was almost 15%.

Using CAPM as a way to determine the returns that investors should expect, having a bi of 1.0 implies that the level of risk associated with the investment is the same as the market and that the average return in the market is appropriate. For bi . 1.0, the stock is riskier than average

Term of Investment 3 month1 month 20 years7 years1 year 3 years 30 years10 years2 years 5 years6 month

In te

re s

t R

a te

0.0%

4.0%

3.0%

2.0%

1.0%

3.5%

2.5%

1.5%

0.5%

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Section 9.3Financial Risk

and requires a higher expected rate of return. For bi , 1.0, the stock is less risky than average and requires a lower expected rate of return. Most stocks have betas in the range of 0.5 to 3.0.

In the practice of corporate finance, analysts regularly calculate bi for companies that have shares of equity that are publicly traded. The estimation of bi comes from statistical analysis of the relationship between the actual returns of companies, as an approximation for expected returns, and an index of actual market returns (e.g., the S&P 500), as an approximation for the expected market returns. Examples of bi for selected large healthcare insurance and managed care and healthcare facility companies are presented in Exhibit 9.5.

Exhibit 9.5 CAPM b for large healthcare organizations

b

WellPoint 0.46 UnitedHealth Group 0.57 Cigna 0.69 Aetna 0.82 Humana 0.89 DaVita HealthCare Partners 1.18 Health Management Associates 1.73 Universal Health Services 1.89 Community Health Systems 1.99 Tenet Healthcare 2.43 Source: http://finance.yahoo.com/ (October 30, 2013).

Presently, equity investments in large healthcare insurance and managed care companies (the first five companies in Exhibit 9.5) are less risky than the market as a whole. In contrast, equity investments in healthcare facility companies are currently more risky than the market as a whole.

With Exhibit 9.5 in mind, consider the following example for the determination of the long- term return that investors should expect for holding the stock of DeVita HealthCare Partners with bi 5 1.18.

E[ri ] 5 rf 1 bi 3 (E[rM ]) 2 rf )

5 5% 1 1.18 3 (15% 2 5%)

5 16.8%

Analyze This What are the expected returns associated with UnitedHealth Group and Tenet Healthcare? Why are these expected returns so different from one another?

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Section 9.3Financial Risk

The CAPM is an approximation and should be used with some caution. It is widely used and quite helpful for estimation purposes, but it should not be considered to be highly precise.

Cost of Equity: Not-for-Profit Organizations Not-for-profit organizations face a special challenge in the use of the capital asset pricing model and other modern finance tools to determine the cost of equity capital, namely that there is no market information on rates of return that can readily be used for analysis. Faced with this challenge, not-for-profit organizations can take one of three approaches: pure-play, accounting-based CAPM, and the accounting net income approach. The pure-play tech- nique suggests that in lieu of actual market information on the risk of equity in a particular organization, one could use the actual market information for a firm that appears to exhibit a similar level of risk and has a similar level of debt. A large not-for-profit health insurance or managed care organization might use a b of 0.46 to 0.89, based on the information in Exhibit 9.5. Similarly, a large system of hospitals might use a b of 1.18 to 2.43. In this later case, the range of observed bs is quite wide, leaving much uncertainty in the appropriate cost of equity capital.

Another option for not-for-profit healthcare organizations is to develop an approximation to the use of CAPM based on accounting net income (Smith & Wheeler, 1989). A statistical analy- sis of accounting net income, as an approximation for market returns, would yield estimates of b that could be used with a traditional CAPM equation. Statistical analysis of accounting data can be quite difficult and should not be attempted by persons who are not well trained in statistics.

A final option for not-for-profit organizations is simply to use average values for accounting net income as the estimated cost of equity capital. The advantage of this approach is that the data are readily available. The disadvantage of this approach is that by eliminating consider- ation of market rates of return, it considers the cost of equity capital for an organization all by itself and, therefore, includes all stand-alone risk. Any consideration of the advantages of diversification through use of portfolios is lost.

Given the effort and uncertainly involved with each approach, use of the pure-play approach may be the best option for most organizations. In additions to large firms listed in Figure 9.4 and Exhibit 9.5, there are more than 20 health insurance companies and managed care orga- nizations and more than 50 hospital companies with stock price information.

For Review: 1. How does financial risk add to business risk?

Financial risk is the risk associated with borrowing money and the requirement to make interest and principal payments, whereas business risk is the risk associated with possible variations in net income. Adding interest to expenses decreases net income and adds to business risk.

2. Why would investors choose to hold a portfolio of investments rather than hold a single investment? A portfolio does not change the expected returns as compared to single investments. A portfolio reduces the risk associated with investing. Having the same expected returns with lower risks is safer for investors.

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Section 9.4Optimal Capital Structure

3. What information does an organization need to have to use the capital asset pricing model? The basic equation for the CAPM is written as

E[ri ] 5 rf 1 bi 3 (E[rM ]) 2 rf )

Therefore, an organization needs to have information on the risk-free rate, the expected return for the market as a whole, and the relative riskiness of the organiza- tion, as measured by beta. Not-for-profit organizations without stock information used to calculate bi may use information from similar companies that do have stock information, an approach that is called the pure-play.

9.4 Optimal Capital Structure Returning to the discussion of financial risk, the use of debt permits organizations to purchase more assets and therefore provide more services than they could by using only net assets. The use of small levels of debt do not materially affect the credit rating and interest rates paid by organizations and do not involve a high degree of financial risk. Not only does the use of large levels of debt harm the credit rating and raise interest rates paid by organizations, but it involve a high degree of financial risk. Since the costs of debt are lower than the expected returns on equity, at least at low levels of use of debt, some level of debt should be used to purchase assets. At higher levels of debt, the use of debt affects the credit rating and interest rates (the costs of debt) and the degree of financial risk. Recalling the relationship between risk and return, the degree of financial risk will affect the expected rate of return (the cost of equity). So what level of debt should be used? What is the optimal capital structure (use of debt and use of net assets) for a healthcare organization?

To determine the optimal capital structure, one can use the information on the use of debt and the cost of debt and the use of equity capital and the cost of equity capital. For the orga- nization as a whole, the percentage use of debt and equity must equal one. Organizations are financed by either debt or equity. For the cost of debt, a bank loan rate or a rate determined by the credit rating can be used. For the cost of equity capital, the CAPM can be used. Putting all of this information together permits the calculation of the weighted average cost of capital (WACC). The WACC is the overall cost of capital, measured as the percentage use of debt, at the cost of debt after taxes, plus the percentage use of equity, at the cost of equity. The equa- tion for the WACC is written as

WACC 5 (Debt 4 Total assets) 3 rd 3 (1 2 Tax rate)

1 (Equity 4 Total assets) 3 re

5 Debt ratio 3 rd 3 (1 2 Tax rate) 1 (1 2 Debt ratio) 3 re

For Bixby Hospital, a not-for-profit that has a 0% tax rate, the current debt ratio is 27.3%, and the current average cost of debt is 1.7% (interest expense divided by total liabilities). However, the current rate that Bixby has been quoted, given its credit rating, is 5.5%, which would be the appropriate rate for future decisions. With an equity ratio (1 2 Debt ratio) of 72.7%, the only missing term is the cost of equity capital. If we conduct an analysis and find that the risk of Bixby Hospital is similar to that of DaVita HealthCare Partners, we may use a

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Section 9.4Optimal Capital Structure

b of approximately 1.18, which yields a long-term expected return on equity capital of 16.8%. Within the WACC equation, the current WACC is

WACC 5 (Debt 4 Total assets) 3 rd 1 (Equity 4 Total assets) 3 re

5 27.3% 3 5.5% 3 (1 2 0%) 1 72.7% 3 16.8%

5 13.7%

With a WACC value of 13.7%, is a debt ratio of 27.3% optimal? To determine whether the WACC is the lowest possible cost of capital, it is helpful to estimate the value of WACC at alter- native uses of debt. An estimation of the value of WACC at levels of debt that range from 0% to 80% for Bixby Hospital is presented in Figure 9.6. The first thing to note from Figure 9.6 is that the WACC is not highly sensitive to the debt ratio. At the lowest levels of debt (10%), the cost of debt is 4.0%, and the cost of equity capital is 14.6%, resulting in a WACC of 14.0%. With more debt, the cost of both debt and equity increases, and the WACC decreases as the cost of debt remains lower than the cost of equity capital. At the highest level of debt (80%), the cost of debt is 14.5%, and the cost of equity capital is 24.1%, resulting in a WACC of 16.5%. A range of 14.0% to 16.5% is a narrow range of estimates of the cost of capital.

Figure 9.6: Weighted average cost of capital (WACC), Bixby Hospital, 2012

Source: Author’s calculations.

The second thing to note from Figure 9.6 is that the minimum point on the WACC curve is quite close to the current debt ratio of 27.3%. The WACC declines only slightly from 14.0% at almost no debt to 13.7% at the current use of debt. In fact, it is not until a use of debt of 65% that WACC increases to more than 15%. Therefore, the current use of debt is acceptable.

Cost of Equity Capital

WACC

Cost of Debt

0% 10%0% 80%70%30% 50% 60%40%20%

30%

25%

15%

5%

20%

10%

Percentage Use of Debt

In te

re s

t R

a te

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Section 9.4Optimal Capital Structure

Spreadsheet Calculation of WACC The calculation of equations such as the WACC can be performed by hand or with a calcula- tor. To ease the task when there are a number of analyses that must be performed, or when there are many observations, electronic spreadsheets may be used instead. A calculation of the WACC for Bixby Hospital is presented in Exhibit 9.6.

Exhibit 9.6 Spreadsheet calculations of weighted average cost of capital, Bixby Hospital, 2012

A B C D E F G

1 Debt Ratio

Cost of Debt Tax Rate

Equity Ratio

Cost of Equity WACC

2 20.0% 4.30% 0% 16.31% 3 27.3% 5.50% 0% 72.3% 16.80% 13.65% =(A3*B3*(1–C3))+(D3*E3) 4 40.0% 6.91% 0% 18.77% 5 Source: Author’s calculations.

Analyze This Using the information in Exhibit 9.6, what are the equity ratios and WACCs for Bixby Hospital at debt ratios of 20% and 40%?

Other Capital Structure Considerations The use of a process of minimizing the weighted average cost of capital to select the optimal level of debt is consistent with the trade-off theory of debt. Making the trade-off between the low cost of debt and the risks associated with using too much debt, the point at which WACC is minimized yields the optimal capital structure. The trade-off theory is popular because it suggests a rational and consistent process for decision making.

An alternative theory of use of debt is the pecking-order theory. The pecking-order the- ory suggests that organizations have preferences about the use of equity capital and debt for financing new projects. Anecdotal empirical evidence tends to support pecking-order theory for hospital systems (Smith, Wheeler, Rivenson, & Reiter, 2000b). Decision making in not-for-profit healthcare organizations often takes into account many factors that are not readily observable, especially the time and managerial expense associated with acquiring debt and equity.

The usual order of preference is to first use available cash (cash and marketable securities, or assets limited as to use if the project is consistent with the limitations). Organizations may wish to first use available cash because it does not involve any interactions with individuals or firms outside of the organization, limiting the time and expense of acquiring new funds.

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Summary & Resources

The second option for funds is typically debt financing. Organizations may obtain short-term loans from banks for small, short-term projects and then seek to issue long-term debt for large, long-term projects. There is time and expense associated with obtaining loans and issu- ing debt, and these costs are well known and work with established methods.

The last option is to seek new equity capital. For investor-owned firms, there is often substan- tially more time and effort involved in new equity offerings, including, perhaps, reporting to the Securities and Exchange Commission. Only for very large firms are methods well known. For not-for-profit firms, seeking new equity capital requires solicitation of philanthropic giv- ing. The philanthropy process is very time-consuming, with uncertain and difficult-to-measure results (Smith & Clement, 2013).

For Review: 1. What information is required to calculate the weighted average cost of capital?

The WACC requires (1) the percentage use of debt, (2) the cost of debt, (3) the tax rate, (4) the percentage use of equity, and (5) the cost of equity. The equation for the WACC is written as

WACC 5 (Debt 4 Total assets) 3 rd 3 (1 2 Tax rate)

1 (Equity 4 Total assets) 3 re

2. What theory of organization decision making suggests that one should use the WACC? The trade-off theory suggests that organizations use information on costs of debt and equity and select the best mix based on WACC. The pecking-order theory suggests that firms do not use the WACC and generally use equity unless they cannot support assets without borrowing money.

Summary & Resources

Chapter Summary This chapter has introduced many important and difficult topics central to the application of modern finance methods to the financial management of healthcare organizations. The concepts of uncertainty and risk can be challenging, even to persons with a good understand- ing of statistics. An important message in this chapter is that organizations face a number of uncertainties. When a point of uncertainty has financial consequences, such as the number of patients that may visit on a particular day, then it is a risk to the organization’s profitabil- ity. Use of some basic statistical tools is necessary to quantify the risk for projects or for the organization as a whole. Given the importance of risk as a determination of expected returns, careful calculation of risk is important for financial managers.

Risks will always exist, and there are ways in which individuals and organizations can seek to reduce their financial impact. One way to reduce risks is to diversify by creating portfolios of investments. As long as all of the investments in a portfolio do not have exactly the same risk, average returns can be earned at lower levels of risk.

In addition to the business risk of an organization, there is financial risk. Financial risk is the added risk associated with using debt to purchase assets. As part of long-term financial

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decision making, organizations select the appropriate level of debt to use and, accordingly, the appropriate the level of equity. The modern finance tool of the capital asset pricing model was introduced as a means to estimate the cost of equity, thereby enabling the calculation of the weighted average cost of capital to determine the appropriate level of debt. Having demonstrated that the precise level of debt may not make a big difference in the WACC, it may seem disappointing to work through the process of calculating the WACC. As will be demon- strated in Chapter 10, the WACC is also essential as the discount rate for investment analysis, and the work will have been worthwhile.

Discussion Questions 1. Borrowing money permits an organization to acquire more assets and involves add-

ing financial risk to the already existing business risk. How much risk is too much? 2. Diversification enables organizations to reduce their overall risk. Does diversifica-

tion explain the development of chains of skilled nursing facilities? 3. The capital asset pricing model is commonly used to evaluate the expected equity

returns for for-profit companies. How valid is it to adopt a for-profit company’s equity return as an approximation for a not-for-profit company’s equity return?

Exercises 1. Eight clinics (A2H) owned by a health system reported their operating margins in

2012. What is the average operating margin and what is the standard deviation of the operating margin? Clinic Operating Margin

A 4% B 5% C 6% D 7% E 8% F 9% G 10% H 11%

2. Four clinics (I2L) owned by a health system reported their operating margins in 2012. What is the average operating margin and what is the standard deviation of the operating margin? Clinic Operating Margin

I 3% J 5% K 10% L 12%

3. If the total dollar amount of operating profit were the same for clinics A2H and clin- ics I2L, which set of clinics would be a better investment?

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4. Soniat Skilled Nursing, Inc. is preparing financial plans for 2013. The current plan is a simple extension of activities in 2012. A proposed plan is similar but includes hav- ing $500,000 less in liabilities. What are the debt ratio and the return on net assets under the current plan and the proposed plan? Which plan would you recommend to the owners of Soniat? Soniat Skilled Nursing Current Plan Proposed Plan Balance sheet Total assets $3,200,000 $3,200,000 Total liabilities $2,500,000 $2,000,000 Total net assets $700,000 $1,200,000

Income statement Net revenues $11,000,000 $11,000,000 Operating expenses, except interest $10,500,000 $10,500,000 Interest expense $100,000 $70,000 Net income before taxes $400,000 $430,000 Tax expense $140,000 $150,500 Net income $260,000 $279,500

5. Soniat Skilled Nursing, Inc. views its risk as being similar to Skilled Healthcare Group, Inc., which is a company listed on the New York Stock Exchange (symbol SKH) with a beta of 0.70. If the long-run average risk-free rate is 5% and the long- run average market rate of return is 15%, what is the long-run average expected return on Soniat using the capital asset pricing model?

6. If the cost of debt to Soniat is measured as the interest expense divided by total liabilities, and the cost of equity is determined by CAPM from Exercise 5, what is the weighted average cost of capital for Soniat under the current plan and the pro- posed plan?

Key Terms accounting-based CAPM An approach to estimating the cost of equity in a not-for- profit organization by using accounting information in the capital asset pricing model.

accounting net income approach An approach to estimating the cost of equity in a not-for-profit organization by simply using accounting net income, without using the capital asset pricing model.

business risk, stand-alone risk The varia- tion in possible returns (profits) associated with the uncertain conditions facing the organization.

capital asset pricing model (CAPM) The model of the expected cost of equity capital (return) for an organization, given its risk relative to the market.

debt covenant A restriction on operat- ing or financial conditions associated with a debt agreement that the organization is required to meet. Failure to meet a debt covenant can result in a requirement to immediately repay a debt or other penalties.

diversification The process of spreading investments across different assets. The purpose of diversification is to decrease risk.

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financial risk The risk added to an orga- nization’s business risk through the use of debt.

firm-specific risk The variation in pos- sible returns (profits) associated with the operations and management of one particu- lar organization.

market risk The variation in possible returns (profits) associated with the industry of an organization and the overall economy.

market risk premium An indicator of, on average, how much higher returns on equity investments are compared to risk-free rates. It is calculated as E[rM] 2 rf .

normal distribution A probability func- tion of the observations from a popula- tion where 68% of the observations will be within one standard deviation, plus or minus, of the average return, and 95% of the observations will be within two stan- dard deviations, plus or minus, of the aver- age return. When there are large numbers of observations, the probability function often exhibits a normal distribution.

pecking-order theory A theory that orga- nizations have preferences about the use of equity capital and debt for financing new projects and generally choose to use equity before debt.

portfolio A group of assets pooled together for investment purposes.

portfolio risk The variation in possible returns (profits) associated with a number of investments, potentially several firms, in several industries, in several economies.

pure-play An approach to estimating the cost of equity in a not-for-profit organiza- tion by using the actual market information for a firm that appears to exhibit a similar level of risk and has a similar level of debt.

trade-off theory A theory that organiza- tions calculate the weighted average cost of capital (WACC) and recognize the trade-off between the low cost of debt and the risks associated with using too much debt.

weighted average cost of capital (WACC) The overall cost of capital mea- sured as the percentage use of debt, at the cost of debt, plus the percentage use of equity, at the cost of equity. The point at which the WACC is minimized represents the optimal use of debt by the organization.

yield curve The line that depicts the relationship between interest rates and the term of a debt as a given point in time.

Suggested Websites

• For data on financial ratios and cost of debt, see Standard & Poor’s: http://www.standardandpoors.com

• For data on interest rates, see Federal Reserve: http://www.federalreserve.gov/ • For data on financial statements, risks, and other information on investor-owned

firms, see the U.S. Securities and Exchange Commission: http://www.SEC.gov • For financial statements and calculation of b, see Yahoo Finance:

http://finance.yahoo.com/

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