Chapter 21 Capital Formation

Learning Objectives 1.Explain the differences between debt and equity financing and the sources of each. 2.Explain the factors that influence the desirability of alternative sources of financing. 3.Explain what an investment banker does. 4.List the major bond rating agencies and explain their role in the debt market. 5.List some of the pros and cons of retiring debt early.

Two Key Questions 1.How much capital is needed? 2.What sources of capital are available?

1.How much capital is needed? 2.What sources of capital are available? Two Key Questions

Distribution in Hospitals Approx 50% Debt Financed Approx 50% Equity Financed How is the financing structure changing?

Three ways to generate new equity financing 1.Profit retention using net income to increase equity (topic discussed extensively in GRIE discussions) 2.Contributions using philanthropic gifts to increase equity 3.Sale of equity interests using the issuance of new ownership interest to increase equity

Contributions/Philanthropy

KEYS TO SUCCESS 1.Case statement Defines why you need money 2.Designated development officer Does not need to be full-time – incentives should relate to giving expectations 3.Trustee and medical staff involvement People give to people, not to organizations 4.Prospect lists Know who in the community are prime prospects for giving 5.Programs for giving Variety of methods and means to encourage giving 6.Goals Define realistic targets

Issuance of Equity Taxable firms have relied heavily on equity issuance to raise capital. Interest in not-for-profit firms has been generated by raising capital through using restructured organizations and taxable entities to raise capital Example not-for-profit organizational structure on next slide

Issuance of Equity Figure 21–1 A Parent Holding Company

Long-term Debt Financing KEY CHARACTERISTICS 1.Cost 2.Control 3.Risk 4.Availability 5.Adequacy

Long-term Debt Financing KEY CHARACTERISTICS 1.Cost Interest rates are the most important characteristic that affects the cost of alternative debt financing Key term: coupon rate – fixed return of a long-term debt instrument Key term: basis point – 1/100 th of 1 percent Issuance costs are simply those expenditures that are essential to consummate the financing

Reserve requirements are sometimes required – these are fund balances in escrow accounts under the custody of the bond trustee. There are two types of reserves: –Debt Service Reserve –Depreciation Reserve Long-term Debt Financing

KEY CHARACTERISTICS 2.Control Investors often will specify some conditions or restrictions that they would like included in the bond contract – such conditions or restrictions are often known as covenants 1.Financial performance indicators (such as current ratio) 2.Future financing (conditions before firm can issue additional debt) Key term: Indenture – the “debt contract” between the parties

Long-term Debt Financing KEY CHARACTERISTICS 3.Risk From the issuer’s perspective, flexibility of repayment terms is highly desirable. The investor, however, wants some guarantee that the principal will be repaid in accordance with some pre-established plan. Prepayment provision: specifies the point in time at which the debt can be retired, and the penalty that will be imposed for an early retirement Call premium: is some percentage of the par or face value of the bonds

Long-term Debt Financing KEY CHARACTERISTICS 3.Risk Debt principal amortization pattern: Level-debt service: the amount of interest and principal that is repaid each year remains fairly constant (most home mortgages) Level-debt principal: equal amount of debt principal is repaid each year. In this pattern of debt retirement, the total debt service payment decreases over time.

Long-term Debt Financing Figure 21–3 Level-Debt Service: Relationship between Interest Payment and Debt Principal

Long-term Debt Financing Figure 21–4 Level-Debt Service: Relationship between Interest Payment and Total Debt Principal

Long-term Debt Financing KEY CHARACTERISTICS 4.Availability Once a health care firm decides that it needs debt financing, it usually wants to obtain the funds as quickly as possible. However, the difference in interest rates may more than offset the costs of delay.

Long-term Debt Financing KEY CHARACTERISTICS 5.Adequacy A key requirement of any proposed plan of financing is that it cover all the associated costs. One of the key areas of adequacy is that of refinancing costs. In many situations, a new construction program that requires financing may not be possible unless existing financing can be retired or refinanced. Not all types of financing permit the issuer to include the costs of refinancing in the amount borrowed.

Long-term Debt Financing Sources SOURCES 1.Tax-exempt revenue bonds Permit the interest earned on them to be exempt from federal income taxation. The primary security for such loans is usually a pledge of the revenues of the facility seeking the loan, plus a first mortgage on the facility’s assets.

If the tax revenue of a government entity is also pledged, the bonds are referred to as “general obligation bonds.” Most tax-exempt revenue bonds are issued by a state or local authority. The health care facility then enters into a lease arrangement with the authority. Title to the assets remains with the authority until the indebtedness is repaid. Long-term Debt Financing Sources

SOURCES 2.Federal Housing Administration (FHA)-insured mortgages FHA-insured mortgages are sponsored by the Federal Housing Administration, but initial processing begins in the Department of Health and Human Services. Through the FHA program, the government provides mortgage insurance for both proprietary and nonproprietary hospitals. This guarantee reduces the risk of a loan to investors and thus lowers the interest rate that a hospital must pay. Long-term Debt Financing Sources

SOURCES 3.Public Taxable Bonds Public taxable bonds are issued in much the same way as tax-exempt revenue bonds, except that there is no issuing authority and no interest income tax exemption. An investment banking firm usually underwrites the loan and markets the issue to individual investors. Interest rates are thus higher on this type of financing than they are on a tax-exempt issue. Long-term Debt Financing Sources

SOURCES 4.Conventional Mortgage Financing Conventional mortgage financing is usually privately placed with a bank, pension fund, savings and loan institution, life insurance company, or real estate investment trust. This source of financing can be arranged quickly, but, compared with other alternatives, does not provide as large a percentage of the total financing requirements for large projects. Thus, greater amounts of equity must be contributed. Long-term Debt Financing Sources

Figure 21– 5 Parties Involved in a Public, Tax- Exempt, Revenue Bond Issue

Long-term Debt Financing Parties Involved Bond ratings Agencies 1.Moody’s 2.Standard & Poors 3.Fitch’s S&P 2009 distribution – stand-alone hospitals AA+/AA 2.8% BBB+ 13.2% AA- 3.8% BBB 14.5% A+ 14.0% BBB- 12.4% A 13.5% NIG 9.4% A- 16.5% totals 100%

Long-term Debt Financing Recent Developments RECENT DEVELOPMENTS 1.variable rate financing 2.pooled or shared financing 3.zero-coupon and original issue discount bonds 4.interest rate swaps

Long-term Debt Financing Early Retirement WHY? 1.Permits the issuer to take advantage of a reduction in interest rates 2.Avoid onerous covenants in the existing indenture 3.Take advantage of changes in bond ratings 4.Take advantage of changes in policy regarding tax- exempt financing

Long-term Debt Financing Early Retirement TYPES? 1.Refinancing The issuer buys back the outstanding bonds from the investors (two ways): A. Option of an early call B. Buy back the bonds in open-market transactions or to send a letter to existing bondholders, offering to buy the bonds at some stated dollar amount.

Refunding Outstanding bonds are not acquired by the issuer, and the present bondholders continue to maintain their investment. The refunding does not actually retire the bonds, but the bonds are not shown on the issuer’s financial statements, and the covenants present in the indenture are now voided (called defeasance) Long-term Debt Financing Early Retirement