1. 8 - 1 CHAPTER 8 Business Financing and the Cost of Capital Business financing basics Interest rate levels Short- and long-term debt financing Equity (ownership) financing Capital structure decisions The cost of capital Copyright © 2013 by the Foundation of the American College of Healthcare Executives

2. 8 - 2 Financing Basics Healthcare providers need capital to acquire the assets needed to provide services. Capital comes in two basic forms: Debt capital, which is supplied by lenders. Equity capital, which is supplied by owners (or by the community). Capital is allocated in a free market economy by price. The businesses most able to pay (those that create the greatest value) get the capital. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

3. 8 - 3 The Cost of Money The interest rate on debt financing is the cost of debt to borrowers. Furthermore, interest rate levels influence the cost of equity capital. Although many factors influence the interest rate set on a particular loan, the two most important are: Risk. The greater the risk, the higher the interest rate. Inflation. The greater the expected inflation rate, the higher the interest rate. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

4. 8 - 4 Short-Term versus Long-Term Debt Short-term debt has a maturity of one year or less. It typically is used to finance temporary cash needs such as seasonal increases in inventories and receivables. Long-term debt has a maturity greater than one year. It typically is used to finance permanent increases in inventories and receivables and investments in land, buildings, and equipment. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

5. 8 - 5 Short-Term Debt Short-term debt has three primary advantages over long-term: Lower issuance costs Fewer restrictive covenants Generally lower interest rate For most providers, commercial banks are the major source of short-term debt. Often, short-term debt is in the form of a line of credit. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

6. 8 - 6 Types of Long-Term Debt Term loans are loans from financial institutions, typically banks. Bonds typically are sold to the public: Treasury bonds are sold (issued) by the federal government. Corporate bonds are issued by for-profit corporations. Municipal bonds are issued by not-for-profit healthcare providers. (Actually, they are issued by governmental financing authorities on behalf of providers.) Copyright © 2013 by the Foundation of the American College of Healthcare Executives

7. 8 - 7 Debt Contracts Debt contracts have several different names: Bond indenture Loan agreement Promissory note They usually contain: General provisions Maturity (when the principal must be repaid) Interest rate and type (fixed or variable) Restrictive covenants Trustee designation (bond issues only) Copyright © 2013 by the Foundation of the American College of Healthcare Executives

8. 8 - 8 Debt Contracts (Cont.) Call provisions Permit the borrower to redeem (pay back) the amount borrowed prior to maturity. Typically a call premium is specified. Call privilege usually is deferred.  Why would borrowers want callability?  What impact does a call provision have on the riskiness of debt financing to lenders? To borrowers? Copyright © 2013 by the Foundation of the American College of Healthcare Executives

9. 8 - 9 Debt Ratings Investment GradeSpeculative* Moody’s AaaAaABaaBaBCaaC S&P AAAAAABBBBBBCCCD Rating agencies assign debt (bond) ratings that reflect the probability of default. Here are some typical ratings: Fitch AAAAAABBBBBBCCCD * Also called “junk” Copyright © 2013 by the Foundation of the American College of Healthcare Executives

10. 8 - 10 Debt Ratings (Cont.) Debt ratings are based on factors such as: Borrower’s financial condition Competitive situation Quality of management Ratings are very important because they “measure” the risk of default on the debt. The lower the rating (the greater the risk), the higher the interest rate that must be set on that debt. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

11. 8 - 11 The other major source of long-term capital is equity financing. In for-profit (investor-owned) businesses, equity is supplied by owners. In not-for-profit (NFP) businesses, “equity” (sometimes called fund capital) is supplied by “the community.” Equity (Owner) Financing Copyright © 2013 by the Foundation of the American College of Healthcare Executives

12. 8 - 12 For-profit businesses are usually organized as: Proprietorships Partnerships Corporations Hybrid forms Our focus here is on corporations, so the owners are stockholders (shareholders). Equity in For-Profit Businesses Copyright © 2013 by the Foundation of the American College of Healthcare Executives

13. 8 - 13 First and foremost, stockholders have a claim on the residual earnings (net income) of the business. Net income “belongs” to shareholders. Some portion may be paid out as dividends. Control of the firm (the proxy process) Preemptive right (the right to purchase any new shares issued.) Stockholders’ Rights and Privileges Copyright © 2013 by the Foundation of the American College of Healthcare Executives

14. 8 - 14 Capital structure is the financing mix used to acquire a business’s assets. Simply put, it is the proportion of debt financing used by a business. The capital structure decision involves identifying the optimal mix of debt and equity (the target capital structure). Future financing is done in a way to keep the actual capital structure at (or close to) the target. Capital Structure Decisions Copyright © 2013 by the Foundation of the American College of Healthcare Executives

15. 8 - 15 Impact of Capital Structure on Risk and Return Consider a new for-profit walk-in clinic that needs $200,000 in assets to begin operations. The business is expected to produce $50,000 in operating income. The clinic has only two capital structure alternatives: No debt financing (all equity). $100,000 of 10%debt (50/50 mix). Copyright © 2013 by the Foundation of the American College of Healthcare Executives

16. 8 - 16 Forecasted P&L Statements All Equity 50% Debt Net revenue $150,000 $150,000 Operating costs 100,000 100,000 Operating income $ 50,000 $ 50,000 Interest expense 0 10,000 Taxable income $ 50,000 $ 40,000 Taxes (40%) 20,000 16,000 Net profit $ 30,000 $ 24,000 ROE 15% 24% Total $ available $ 30,000 $ 34,000 Copyright © 2013 by the Foundation of the American College of Healthcare Executives

17. 8 - 17 Discussion Items Based on net income, should the clinic use debt financing? What is the total dollar return to investors, including both owners and creditors? Where did the extra $4,000 come from? Copyright © 2013 by the Foundation of the American College of Healthcare Executives

18. 8 - 18 Conclusions Although the use of debt financing lowers net income, it increases the return to equityholders. Debt financing allows more of a business’s operating income to flow through to investors. Because debt financing levers up (increases) return to owners, its use is called financial leverage. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

19. 8 - 19 Conclusions (Cont.) However, our analysis has ignored the fact that operating income is not known with certainty. When uncertainty is considered: The use of debt financing increases owner’s risk. The greater the amount of financial leverage, the greater the risk. Thus, rather than being clear cut, the capital structure decision involves a classical risk/return trade-off. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

20. 8 - 20 Trade-Off Theory of Capital Structure The trade-off theory indicates that there is an optimal capital structure for every investor-owned business that balances the costs and benefits of debt financing. The optimal structure: Includes some debt But not too much debt Although developed for for-profit businesses, the trade-off theory also roughly applies to not-for-profit businesses. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

21. 8 - 21 Some Factors That Influence Capital Structure Decisions In Practice Unfortunately, capital structure theory cannot be used in practice to find a business’s optimal structure. Here are some factors that influence the decision: Asset structure Inherent business risk Lender/rating agency attitudes Reserve borrowing capacity Industry averages Copyright © 2013 by the Foundation of the American College of Healthcare Executives

22. 8 - 22 Optimal Debt Maturity Structure Once the optimal capital structure is estimated, businesses must choose between long-term and short-term debt. In general, debt should be chosen with maturities that match the maturity of the assets being financing. Permanent assets (such as land and buildings) should be financed with long- term debt. Temporary assets (such as a seasonal buildup in inventories) should be financed with short-term debt. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

23. 8 - 23 Cost of Capital Basics The corporate cost of capital is a blend (weighted average) of the costs of a business’s permanent financing sources. It is used as a benchmark rate of return in the evaluation of proposed projects. It is based on the marginal (current) costs of a business’s permanent financing components (typically long- term debt and equity). Copyright © 2013 by the Foundation of the American College of Healthcare Executives

24. 8 - 24 Estimating the Component Cost of Debt Discuss debt costs with banker: Investment banker if bonds are used Commercial banker if loan is used Look at current yields on outstanding bond issues if they are actively traded. Look to the debt markets for guidance. Find the interest rate on debt recently issued by similar companies. Find out the prime rate. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

25. 8 - 25 Component Cost of Debt (Cont.) For a not-for-profit business, the cost of debt is the unadjusted interest rate. An investor-owned business must recognize the tax benefits of debt: Assume that Major Hospital Chain (MHC) has a 40% tax rate (T). According to its bankers, a new bond issue would require an interest rate of 10%. Its effective cost of debt is 10% x (1 - T) = 10% × 0.6 = 6.0%. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

26. 8 - 26 Component Cost of Equity The component cost of debt is the return required by debt suppliers, and the cost of equity is defined similarly. Equity investors (owners) must set required rates of return based on the returns available on alternative investments of similar risk. The debt cost plus risk premium method is one way to estimate the cost of equity. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

27. 8 - 27 Debt Cost Plus Risk Premium Method The difference between the cost of equity and the cost of debt for a given business reflects the risk premium for bearing ownership risk versus creditor risk. Historically, this premium has been estimated at 3 to 6 percentage points. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

28. 8 - 28 Debt Cost Plus RP Method (Cont.) Assume that the current risk premium is estimated to be 4 percentage points. Then, the debt cost plus risk premium estimate for Major Hospital Chain’s (MHC’s) cost of equity is 14.0%: Cost of equity = Cost of debt + Risk premium = 10.0% + 4.0% = 14.0%. Note: The before-tax cost of debt is used in this model. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

29. 8 - 29 Assume target weights of 35% debt and 65% equity. What is MHC’s corporate cost of capital (CCC)? CCC= w d × Cost of debt x (1 - T) + w e × Cost of equity = (0.35 × 10% × 0.6) + (0.65 × 14.0%) = (0.35 × 6.0%) + (0.65 × 13.9%) = 2.1% + 9.1% = 11.2%. Note: w d is the target proportion of debt and w e is the target proportion of equity. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

30. 8 - 30 Corporate Cost of Capital Interpretation The corporate cost of capital is used as the hurdle rate when new capital investments are being evaluated. However, it reflects the risk of the a business’s average project, so it can be used only for projects of average risk. The corporate cost of capital must be adjusted when the project being evaluated has non-average risk. Copyright © 2013 by the Foundation of the American College of Healthcare Executives

31. 8 - 31 Risk and the Cost of Capital Adjustment Low Project Cost of Capital (%) CCC = 11.2 Project Risk HighAverage Copyright © 2013 by the Foundation of the American College of Healthcare Executives

32. 8 - 32 This concludes our discussion of Chapter 8 (Business Financing and the Cost of Capital). Although not all concepts were discussed in class, you are responsible for all of the material in the text.  Do you have any questions? Conclusion Copyright © 2013 by the Foundation of the American College of Healthcare Executives