1. 13 - 1 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cost of Capital and Capital Structure Choosing between debt and equity Cost of capital concepts Estimating the cost of capital “Optimal” capital structure determination

2. 13 - 2 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cost of Capital Basics Sources of organizational capital Debt -- bonds, term loans, debentures Equity -- retained earnings, stock Capital structure defined -- “mix” of debt/equity capital utilized Cost of capital defined Debt -- interest/coupon rate Equity -- dividends, opportunity costs

3. 13 - 3 Copyright © 1999 by the Foundation of the American College of Healthcare Executives The corporate cost of capital is a blend (weighted average) of the costs of the financing components. (WACC) WACC Equation: WACC = [(Wd)*(Kd)*(1-T)] + [(We)*(Ke)] WACC assumption -- Optimal structure implied by weights (Wd, Kd) Interpretation of WACC estimate Use of historical vs. marginal costs Cost of Capital Basics

4. 13 - 4 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Estimating the WACC: Cost of Debt (Kd) Discuss current debt cost with banker: Investment banker if bonds are used. Commercial banker if loan is used. Look at YTM on outstanding issues if actively traded (PV, maturity, coupon) Look to the debt markets for guidance. Find the interest rate on recent issues: By companies with same debt rating. By companies that are similar (size, risk)

5. 13 - 5 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cost of Debt (Kd) For a not-for-profit organization, the component cost of debt is the interest rate on a new issue. An investor-owned organization must consider the tax benefits of debt: Assume that Valley Clinic (VC) has a 40% tax rate. According to its bankers, a new bank loan would have an interest rate of 10%. Its effective cost of debt (Kd) would be 10% x (1 - T) = 10% x 0.6 = 6.0%.

6. 13 - 6 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cost of Debt (Kd) Not-for-profit organization Kd Tax exempt municipal bond financing Kd comparisons with FP organizations

7. 13 - 7 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cost of Equity Capital (Ke) The effective cost of debt (Kd) is the return required by debt suppliers, and the effective cost of equity (Ke) is defined similarly. For investor-owned businesses the primary sources of equity are: Retained earnings. (Kre) New common stock sales. (Ks)

8. 13 - 8 Copyright © 1999 by the Foundation of the American College of Healthcare Executives The cost of new common stock (Ks) is the rate of return that investors require on that stock. The cost of retained earnings as an opportunity cost of capital: If earnings are retained rather than paid out as dividends, the stockholders bear an opportunity loss. These funds could be reinvested in alternative investments of similar risk. Cost of Equity (Ke)

9. 13 - 9 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Thus, retained earnings have roughly the same cost as does similar forms of common stock. There are three primary methods used to estimate the component cost of equity in FP businesses: Capital Asset Pricing Model (CAPM) Discounted cash flow (DCF) model Debt cost plus risk premium model Cost of Equity (Ke)

10. 13 - 10 Copyright © 1999 by the Foundation of the American College of Healthcare Executives CAPM Method (Ke estimation) The Capital Asset Pricing Model (CAPM) is a equilibrium model that relates market risk to required rate of return. The equation used is the Security Market Line (SML): R(Ri) = RF + [R(R M ) - RF] x b i.

11. 13 - 11 Copyright © 1999 by the Foundation of the American College of Healthcare Executives CAPM Method (Cont.) Input values to CAPM estimate “Risk free” rate (RF) estimation -- matching to avg. stock holding period Required market returns (R(Rm)) Sources of data Choice of observation period(s) Market beta value of stock Definition/different types of betas Regression estimate

12. 13 - 12 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Some Recent (1998) Beta Estimates Alza Drug delivery systems 1.40 Baxter Medical Supplies 1.10 Beverly Enterprises Nursing homes 1.20 Glaxo Wellcome Diversified drugs 1.00 HEALTHSOUTH Rehabilitative care 1.35 Humana Managed care 1.55 Phycor Practice management 1.35 Tenet Healthcare Acute care hospitals 1.00 U.S. Surgical Medical Equipment 1.30 Valley Clinic (VC) Outpatient care 1.10 Source: Value Line

13. 13 - 13 Copyright © 1999 by the Foundation of the American College of Healthcare Executives R(Ri) = RF + [R(R M ) - RF ] x bi = 8.5% + (13.5% - 8.5%) * 1.1 =14.0%. = Estimate of Ke for common stock (Limitations of CAPM estimates for Ke) CAPM Method (Cont.) What is Valley Clinic’s cost of equity (Ke) if RF = 8.5%, R(Rm) = 13.5%, and bi = 1.1?

14. 13 - 14 Copyright © 1999 by the Foundation of the American College of Healthcare Executives DCF Method (Ke estimation) The discounted cash flow (DCF) approach assumes that stock price is the present value of the expected dividend stream. The DCF method can be used both with constant and nonconstant growth, but the calculations are more complicated when growth is nonconstant.

15. 13 - 15 Copyright © 1999 by the Foundation of the American College of Healthcare Executives DCF Method (Cont.) Under constant growth assumptions, the DCF model is as follows: E(Ri) = R(Ri) = + E(g). E(D 1 ) P0P0

16. 13 - 16 Copyright © 1999 by the Foundation of the American College of Healthcare Executives DCF Method (Cont.) Where do we get the input values? P 0 comes from the Wall Street Journal (or many other sources). E(D 1 ) can come from: Analyst’s estimates Historical growth rates Retention growth model estimates

17. 13 - 17 Copyright © 1999 by the Foundation of the American College of Healthcare Executives DCF Method (Cont.) Assume that P 0 = $40, E(D 1 ) = $2.72, and E(g) = a constant 7.0% for Valley Clinic. Then, R(Ri) = + E(g) = + 7.0% E(D 1 ) P0P0 $2.72 $40 = 6.8% + 7.0% = 13.8% = Ke estimate

18. 13 - 18 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Equity Issuance Costs Issuance costs on equity sales are larger than on debt sales. Two methods are used to adjust the cost of equity for issuance costs: Adjust project cost (add-on cost) Adjust cost of equity, which produces two costs: one for retained earnings and one for new stock sales.

19. 13 - 19 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Debt cost plus risk premium method (Ke estimation) Ke as a function of Kd and a stock’s risk premium (Ke = Kd + RPs) RPs ranges from 4-7% above Kd based on historical data Effect of interest rates on Kd and stock risk premiums High interest rates -- low RPs Low interest rates -- high RPs

20. 13 - 20 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Ke estimation methods (comparison) When CAPM, DCF, & DCPRP estimates for the cost of equity (Ke) differ, judgment must be applied. For our provider, the CAPM estimate is 14.0% and the DCF estimate is 13.8%. A reasonable final estimate is 13.9%.

21. 13 - 21 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cost of retained earnings (Ke) Opportunity cost to organizational shareholders Applicable to FP and NFP organizations Conceptual challenge of Ke estimation (missing market for retained earnings) Approaches to estimating Ke Replacement cost estimate (estimated growth in fixed assets over time) Opportunity cost estimate (Ke for stock of similar investment risk and size)

22. 13 - 22 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Assume target weights of 35% debt and 65% equity. What is Valley Clinic’s Weighted Avg. Cost of Capital? WACC= [Wd x Kd x (1 - T)] + [We x Ke] = (0.35 x 10% x 0.6) + (0.65 x 13.9%) = (0.35 x 6.0%) + (0.65 x 13.9%) = 2.1% + 9.0% = 11.1%.

23. 13 - 23 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Interpretation of WACC estimate “True” opportunity cost of capital Normative economic implications “Hurdle” rate for proposed capital investments (minimum acceptable) Technical issues with WACC Deviations from optimal structure -- effect on WACC Applies only to average risk assets/investments

24. 13 - 24 Copyright © 1999 by the Foundation of the American College of Healthcare Executives What factors influence a company’s corporate cost of capital? Market conditions Interest rates (effect on Kd and Ke) Tax rates (effect on Kd) Firm conditions Capital structure policy Capital investment policy (business risk, use of financial and operational leverage

25. 13 - 25 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Risk and the Cost of Capital Low Cost of Capital (%) Corporate Risk HighAverage

26. 13 - 26 Copyright © 1999 by the Foundation of the American College of Healthcare Executives The Capital Structure Decision The funds used to finance a business’ assets are called capital. Capital structure is the financing mix on the right side of the balance sheet. The capital structure decision revolves around this question: Is there an optimal mix of debt and equity (as implied in WACC equation) that will maximize the value of the firm?

27. 13 - 27 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Risk and Return Implications of Capital Structure Decisions Consider a new for-profit ambulatory care clinic that needs $200,000 in assets to begin operations. The business is expected to produce $50,000 in operating income. It has two capital structure alternatives: No debt financing (all equity). $100,000 of 10% interest debt (50/50 mix).

28. 13 - 28 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Pro Forma Balance Sheets Stock Stock/Debt Current assets $100,000 $100,000 Fixed assets 100,000 100,000 Total assets $200,000 $200,000 Bank loan (10% cost) $ 0 $100,000 Common stock 200,000 100,000 Total claims $200,000 $200,000

29. 13 - 29 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Pro Forma Income Statements Revenues $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 income $ 30,000 $ 24,000 ROE 15% 24% Total to investors $ 30,000 $ 34,000

30. 13 - 30 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Conclusions Debt financing levers up (increases) the rate of return (ROE) to owners. Thus, the use of debt financing is called financial leverage. But, with uncertainty, the use of debt financing also increases owner’s risk. Thus, the decision is not clear cut. The capital structure decision involves a classical risk/return trade-off.

31. 13 - 31 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Business risk is the uncertainty inherent in a business’s operating income; that is, how well can managers predict operating income? Business risk does not consider financing. Business Risk Probability EBITE(EBIT)0 Low risk High risk

32. 13 - 32 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Factors that Influence Business Risk Uncertainty about utilization rates Uncertainty about reimbursement Uncertainty about costs Liability uncertainty The degree of operating leverage (% of fixed to total costs) -- synergy with financial leverage

33. 13 - 33 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Financial Risk Financial risk is the additional risk placed on owners when debt financing is used (default risk) The greater the proportion of debt financing, the greater the financial (default) risk Diff. between ROE(U) and ROE(L)

34. 13 - 34 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Capital Structure Theory Capital structure theory attempts to define the relationship between debt financing and firm/equity value for investor-owned businesses. Tradeoff models of capital structure Developed by Modigliani and Miller Organizational “trade off” between costs (increased risk) and benefits (increased returns) of debt capital

35. 13 - 35 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Tradeoff Models of Capital Structure VL = VU + (T x D) - PVD VL = equity value of unleveraged firm VU = equity value of leveraged firm T = firm’s marginal tax rate D = amount of debt capital used PVD = PV of financial distress costs Bimodal relationship between VL and level of debt capital utilized

36. 13 - 36 Copyright © 1999 by the Foundation of the American College of Healthcare Executives % 15 D/A Cost of Equity Corporate Cost of Capital Cost of Debt $ D/A Equity Value

37. 13 - 37 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Tradeoff Theory Limitations Minimal power to explain actual capital structure preferences of different firms e.g. emerging firm reliance on retained earnings, mature firms reliance of debt, large differences in capital structure among similar industries/firms Inconsistency of tax-related effects on capital structure decisions for investor- owned firms

38. 13 - 38 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Asymmetric Information Model Model assumptions Information asymmetry between managers and investors Managers exist to maximize equity value Model predictions “Pecking order” of preferences for capital Dependent on magnitude of information asymmetry present, perceived future growth prospects of the firm, presence of tangible vs. intangible assets

39. 13 - 39 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Asymmetric Information Model Emerging firms Low level of tangible assets (equity) High growth prospects (equity/debt) Significant information asymmetry (debt) Mature firms High level of tangible assets (debt) Low growth prospects (debt/equity) Low information asymmetry (debt) High information asymmetry (equity)

40. 13 - 40 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Summary Implications of Various Capital Structure Theories Tax-related benefits of debt financing increase equity value of firm Costs of financial distress (bankruptcy costs) variably offset the benefits of debt financing as debt level increases Due to information asymmetries, firms will use variable amounts of debt vs. equity capital based on several factors.

41. 13 - 41 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Implications of Capital Structure Theory There is an optimal, or target, capital structure for every investor-owned business that balances the costs and benefits of debt financing. Unfortunately, capital structure theory can not be used in practice to find a business’s optimal structure.

42. 13 - 42 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Factors That Influence Capital Structure Decisions In Practice Organizational viability consideration Organizational financial risk prefs Lender/rating agency risk prefs Level of reserve borrowing capacity Industry benchmarks for risk Shareholder control issues Organizational asset structure Projected growth rate/profitability Organizational taxation issues

43. 13 - 43 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Not-For-Profit Businesses The same general concepts apply to not-for-profit businesses: There is a benefit to debt financing (tax- exempt bond financing) There also are costs However, not-for-profit firms do not have the same financial flexibility as do investor-owned businesses. Implications for capital structure