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OCR for page 47
'2 Financial Capital and
~ Heals Care Grows Trends
First on most lists offactors explaining the
growth of investor ownership and multi-in-
stitutional systems is "access to capital." Al-
though capital costs represent a relatively
small proportion of health care costs (on av-
erage, approximately 7 percent of hospital
costs under the Medicare program), capital
expenditures (for example, for new tech-
nologies) often translate into higher oper-
ating costs. Access to capital by health care
institutions is crucial not only to their own
fixture but to the fixture shape and config-
uration of the health care system itself. Ac-
cess to capital is also integral to the topic of
this report, because it is affected (by defi-
nition and in practice) by whether institu-
tions are for-profit, not-for-profit, or
government owned. It is also a topic about
which there are many misconceptions.
The purpose of this chapter is to explain
the nature and importance of capital, to dis-
cuss the factors that affect institutions' ac-
cess to capital and the cost of that capital,
and to identify the costs that are associated
with the use of different sources of capital.
Although the committee did not get into the
details of policy options regarding capita!, 2
it did examine some of We implications of
Portions of this chapter are based on material pre-
pared by committee member Uwe Reinhardt, Ph. D.,
who also prepared the analysis of the cost of equity
capital that is appended to this chapter.
47
the for-profit/not-for-profit distinction for
capital policy in health care.
WHAT IS CAPITAL?
Like any form of organized economic ac-
tivity, health care organizations need finan-
cial capital to card out their functions. Before
an organization can provide services or un-
dertake a new program, it must use financial
capital to purchase or rent space, equip-
ment, supplies, labor, and so forth that is,
to prepay for certain inputs used in the pro-
duction of health services. Normally, these
prepayments are expected to be recovered
eventually through cash revenues earned by
rendering health services or, in the case of
some public or not-for-profit institutions, from
nonoperating revenues (e.g., charitable
contributions, governmental appropria-
tions, income of subsidiary organizations).
At any point in time, the dollar amounts
of the unrecovered prepayments are listed
as "assets" on the organization's statement
of financial position (or balance sheet). Ta-
bles 3.1 and 3.2 show the balance sheets of
two heal care organizations a not-for-profit
HMO (the Harvard Community Health Pow)
and an investor-owned hospital company
(Humane, Inc.). As the figures show, a heal
care provider's assets include not only real
capital assets such as movable and fixed
equipment, land, and buildings but also
OCR for page 48
48
FOR-PROFIT ENTERPRI SE IN HEALTH CARE
TABLE 3.1 Harvard Community Health Plan, Inc., Balance
Sheet, September 30, 1984
Assets (cumulative uses of funds)
Current Assets
Cash and equivalents
Investments, at cost~uoted market price of
$8,591,000
Accounts receivable
Member premiums, less collection allowances of
$414,000
Grants
Estimated contractual settlements with hospitals
Other, less collection allowances of $455,000
Supplies inventory
Prepaid expenses
Total current assets
Long-Lived Assets
Land, buildings, and equipment, less accumulated
depreciation
Funds held by trustee
Bond issue costs
Over
Total long-lived assets
Total Assets (total uses of funds)
f
Liabilities and Fund Balances (cumulative sources of funded
Current Liabilities
Accounts payable and accrued expenses
Amounts payable to HCHP Fndn., Inc., net
Accrued claims payable- hospitals and physicians
Unearned premium revenue and advance payments
Unearned grant revenues
Current installments of long-term debt
Total current liabilities
Construction Costs Payable, from trusteed Finds
Long-Term Debt, less current installments
Fund Balances
Operating funds
Utilization reserve
Operating and board-designed fiend balances
Total Liabilities and Fund Balance (total sources of
funds)
$ 22,742,810
8,743,152
2,876,677
80,457
722,790
1,255,271
765,624
1,116,130
38,302,911
59,506,139
15,303,907
3,764,405
2.076,127
80,650,578
$118,953,489
$ 10,178,124
279,237
11,997,683
2,106,509
116,485
206,636
24,944,674
5,090,405
63,528,205
1S,912,155
9.478,050
25.390.205
$118,953,489
SOURCE: Adapted from Harvard Community Health Plan, Inc. (1984).
supplies, certain financial assets (cash, mar-
ketable securities, and accounts receivable),
and any other for of prepayment such as
prepaid interest and rent. Assets for which
recovery of the prepayment through earned
revenues is expected within a year are usu-
ally grouped under the heading of"current
assets" or working-capital assets. Prepay-
ments expected to be recovered through
revenues earned over a longer span of time
are referred to as fixed or Tong-lived assets.
The latter consist mainly of equipment,
structures, and land owned by the organi-
zation and represent a substantial (but far
from the total) amount of the total financing
that an organization needs in order to op-
erate.3
Access to financial capital is essential to
OCR for page 49
FINANCIAL CAPITAL AND GROWTH TRENDS
49
any health care organization that would re- pending on assumptions, from $100 billion
spond to changes in its community, acquire to nearly $260 billion (ICF Incorporated,
new technologies and replace old equip- 1983; Cohen and Keene, 1984:24-26~. As
ment, renovate or replace deteriorated fa- sessments of the ability of health care or
cilities, offer new programs or new services,
or make changes to improve productivity or
enhance quality. Much attention has been
given to the aggregate fixture needs for fi
nancial capital among hospitals. Estimates
of such needs in the 1980s vary widely, de
ganizations to raise needed capital vary as
well.
Clearly, with overall hospital occupancy
at 66 percent, there are many areas of the
country in which the supply of hospital beds
is excessive. However, even if a significant
TABLE 3.2 Humana, Inc., Consolidated Balance Sheet,
August 31, 1984
Assets (cumulative uses offends)
Current Assets
Cash and cash equivalents
Accounts receivable less allowance for loss of
$59,215
Inventories
Other current assets
Total current assets
Property Equipment, at cost
Land
Buildings
Equipment
Construction in progress (estimated cost to complete
and equip aRer August 31, 1984: $246,000)
Subtotal
Accumulated depreciation
Other Assets
Total Assets (total uses of fiends)
Liabilities and Stockholders' Equity
Current Liabilities
Trade accounts payable
Salaries, wages, and other compensation
Other accrued expenses
Income truces
Long-term debt due within one year
Total current liabilities
Long-Term Debt
Deferred Credits and Other Liabilities
Common Stocld:~olders' Equity
Common stock, 16-2/3¢ par; aubhonzed 200,000
shaves; issued and outsang 96,848,643
Capital in excess of par value
Translation adjustments
Retained earnings
Total Liabilities and Owners' Equity (total sources of
fiends)
$ 260,954
257,675
45,249
41.428
605,306
165,413
1,228,701
681,756
160.079
2,235,949
452,641
1,783,308
189.233
$2,577,847
$ 88,323
52,292
97,936
59,956
53,720
352,227
1,286,526
195,909
16,141
219,218
(19,340)
527,166
743,185
$2,577,847
SOURCE: Adapted Tom Humana, Inc. (1984).
OCR for page 50
50
number of hospitals should close, there are
many purposes for which other health care
institutions will have substantial needs for
capital funds in the future. Debt must be
retired. Facilities and equipment must be
kept current and in good repair. Some hos-
pitals (or portions thereof will need to be
reconfigured; alternative sites will have to
be developed for Tong-term care and am-
bulatory care; and other steps will be nec-
essary if hospitals are to become more
comprehensive health care organizations.
Also, certain areas of the country have rapid
population growth, and new facilities or ex-
pansions of existing hospitals may be needed.
Thus, health care institutions have and
will continue to have substantial capital
needs, and access to capital translates di-
rectly into institutional ability to grow and
even to survive. Differences among health
care sectors in their access to capital will
shape the future makeup of the health care
system.
SOURCES OF CAPITAL FUNDS FOR
HEALTH CARE PROVIDERS
Financing for the current and long-lived
assets owned by a health care provider can
be obtained from the following sources:
~ philanthropy (or an endowment set up
from philanthropic fiends received in the past)
· grants or other appropriated money Tom
government
· funds accumulated from past opera
tions
· the sale of short-term and long-term
debt instruments
· the sale of ownership certificates (stock).
One other source available in some in-
stances is Finds from the sale of assets al-
ready owned.
Thus, whether an institution has access
to financial capital depends on at least one
of three things: whether it can attract phi-
lanthropy (a source that as a practical matter
is not available to for-profit institutions);
FOR-PROFIT ENTERPRISE IN HEALTH CARE
whether it can obtain governmental grants
or appropriations, which were a major source
of capital for not-for-profit hospitals during
the Hill-Burton era from the late 1940s until
the 1970s, but are available now only to gov-
ernment-owned hospitals (federal, state, or
local); or whether it has earnings (or poten-
tial earnings). Earnings are not only an im-
portant source of capital, they are also crucial
to an organization's ability to secure fiends
through borrowing or through seeing shares.
Funds accumulated Tom business oper-
ations are, in principle, a source of financial
capital that is available to any ongoing or-
ganization, regardless of ownership type.
Such funds are created when an organiza-
tion's annual cash revenues exceed its cor-
responding annual cash expenses. Tables 3.3
and 3.4 show statements that detail the
sources of funds accumulated during 1984
by the Harvard Community Health Plan and
Humana, Inc. These so-called flow-of-filnds
statements also indicate how the funds were
used in 1984. Funds accumulated from op-
erations are shown in the first few lines of
each statement, although they are labeled
differently.
The cash revenues of investor-owned hos-
pitals include return-on-equity payments
from Medicare (and certain other third-party
payers), a source of funds that is not avail-
able to the not-for-profit sector.4 The ratio-
nale of such separate return-on-equity
payments is closely linked to cost-based
reimbursement methods, which are now
being phased out by Medicare. Interest ex-
penses (that is, payments to lenders) have
been a reimbursable expense, but dividend
payments to investors were not so treated,
either in accounting or in reimbursement
rules. Yet, as is discussed later in this chap-
ter, suppliers of equity financing the
shareholders supply these fiends in the ex-
pectation that they will earn an appropriate
rate of return on their investments. The
willingness of the investors to provide such
hinds depends. at minimum, on their being
able to expect a return on their investment
OCR for page 51
FINANCIAL CAPITAL AND GROWTH TRENDS
TABLE 3.3 Harvard Community Health Plan, Inc.- Statement of Sources and Uses of
Cash and Marketable Securities for the Fiscal Year Ended December 31, 1984
,
Sources of Funds
From Operations
Excess of revenues over expenses as reported
Add back: Reported expenses that did not
require an outlay of funds (depreciation and
amortization)
From External Sources
Trade credit
Advances on as yet unearned grant revenue
Proceeds from sale of long-term bonds
Increase in long-term construction costs payable
Total Sources of Funds in 1984
51
Uses of Funds
Investments in Assets
$ 7,975,239
3,602,698
4,813,751
35,500
49,035,000
5,090,405
$11,577,937 (16%)
58,974,656 (84%)
$70,552,593 (100%)
Increases in inventories, accounts receivable and
prepaid expenses$ 2,351,806 ~
Increases in land, buildings, equipment33,558,891 ~$51,804,850 (73%)
Increase in other assets617,280
Increase in funds held by trustees15,276,873 J
Repayment of Debt
Decrease in accounts payable421,126
Repayment of long-term debt5,209,148 5,630,274 (8%)
Other
Bond issue cash
Decrease in unearned premiums
Net Increase in Cash and Marketable Securities
Total Uses of Funds in 1984
SOURCE: Adapted from Harvard Community Health Plan, Inc. (1984~.
that would be equivalent to or higher than
the earnings they sacrificed by supplying
their funds to the hospital sector rather than,
say, to the food or electronics industries.
While such a return is not properly por-
trayed as an entitlement, it must in fact be
paid if the hospital sector hopes to continue
to procure funds on this basis. If investor-
owned hospitals were reimbursed strictly on
a cost basis, without this allowance for the
cost of equity financing, then the suppliers
of such funds would not earn any return and
that source of funds would dry up. How-
ever, under a prospective rate-setting sys-
tem, as with a charge-based system, the
opportunity exists for institutions to gen-
erate fiends in excess of costs.
Prior to 1982, Medicare's return-on-
equit,v allowance for investor-owned hos
3,913,718
42,833 )
3,956,551 (6%)
9,160,918 (13%)
$70,552,593 (100%)
pitals was set at 1.5 times the rate of return
earned by Medicare's Hospital Insurance
Trust Fund on its investments. Legislation
passed in 1982 reduced the amount of re-
turn-on-equity payments to the same rate
as the trust fund. However, return on equity
remains a significant source of capital,
amounting to an estimated $200 million in
1984, about 7 percent of Medicare capital
payments to hospitals and 3840 percent of
Medicare capital payments to investor-owned
hospitals.5 With the phasing out of cost-based
reimbursement, the rationale for separate
retum-on-equity payments to investor-owned
facilities becomes much less clear. The
question will undoubtedly be addressed in
legislation on how Medicare should pay cap-
ital expenses in the fixture, a topic examined
later in this chapter.
OCR for page 52
SOURCE: Adapted from Humana, Inc. (1984~.
In addition to recoveries of earlier expen-
ditures through revenues for depreciation
and amortization expenses, for-profit enti-
bes commonly subtract Tom Me income they
report to shareholders certain income tax
expenses that did not occasion an outflow of
funds during the fiscal year covered by the
report.
The cash revenues of both for-profit and
not-for-profit (as well as public) institutions
also include fiends that represent the recov-
ery of earlier cash outlays that have been
carried as "assets" on the provider's balance
sheet. These recoveries-the most common
of which are "depreciation and amortiza-
tion"- are shown on the income statement
52
FOR-PROFIT ENTERPRISE IN HEALTH CARE
TABLE 3.4 Humana, Inc., Consolidated Statement of Sources and Uses of Cash for the
Year Ended August 31, 1984 (in thousands of dollars)
Sources of Cash
From Operations
Net income, as reported to shareholders$193,341 ~
Add back: reported expenses that did not require an|
outlay of cash in 1984~
Depreciation120,560 , $346,930 (41%)
Deferred income taxes7,404
Increase in allowance for professional liability risk22,032
Other3 593,
From External Sources
Increases in short-term debt50,626
Increases in long-term debt358,811 ~
Issuance of common stock9,695 J 419,132 (49%)
Sale of Properties arid Investments 58,187 (7%)
Other Sources 20,124 (3%)
Total Sources of Cash in 1984 $844,373 (100%)
Uses of Cash
Investments in Assets
Increases in current assets
Increases in property and equipment
Increases in investment in subsidiaries
Reductions in Debt
Repayment of short-tenn debt
Repayment of long-terTn debt
Redemption of Preferred Stock
Payment of Cash Dividend
Over Uses of Cash
Increase in Cash Balance
Total Uses of Cash in 1984
$ 72,841
445,741
23,566 )
2,890
137,067
$542,148 (64%)
139,957 (17%)
62,277 (7%)
60,217 (7%)
28,868 (3%)
10~906 (who)
$844,373 (100%)
as expenses and are deducted from revenues
to arrive at what for-profit entities call "net
profits" and what not-for-profit entities refer
`` ~ ,,
to as excess or revenues over expenses
the proverbial bottom line in either case. It
follows that the net profits or excess reve-
nues shown in annual reports tend to un-
derstate significantly the hinds a hospital
earns from operations in any given year. To
eliminate the distortion, a properly exe-
cuted flow-of-fimds statement therefore adds
back to reported income these noncash ex-
penses (see Figures 3.3 and 3.41.
The current tax code provides one other
source of working capital for for-profit or-
ganizations in the form of investment in
OCR for page 53
FINANCIAL CAPITAL AND GROWTH TRENDS
centives, which allow companies to recover
their investment costs more quickly by de-
ferring a portion of their corporate income
taxes. Table 3.5 shows corporate truces paid
by the four largest investor-owned hospital
companies in relationship to several differ-
ent financial measures: The percentage of
taxes that are deferred (and that are there-
fore available as working capital) vary, de-
pending primarily on Me investment patterns
of the companies. Because Humana has not
been investing heavily in new facilities, its
taxes paid in 1983 were at 77 percent of the
53
statutory rate, and deferred taxes provided
only a minor source of working capital ($7.4
million of almost $800 million of Finds pro-
vided), as Table 3.4 shows. Deferred taxes
were a more important source of Finds for
other companies, however. NME paid taxes
at the rate of only 29 percent of the statutory
rate in 1983 (Table 3.5), and deferred taxes
constituted almost 8 percent of NME's new
working capital in 1984 (National Medical
Enterprises, 19841.
In reporting the sources of"funds from
operations" in its flow-of-funds statement,
TABLE 3.5 Income Tax Obligations and Payments of Four Investor-Owned Health Care
Corporations, Fiscal Year Ending 1983 (in thousands of dollars)
AMI Humana
HCA NME
Gross revenues$2,217,862$2,298,608$3,917,057$2,148,000
Net income before taxes233,441288,782391,718170,000
Statutory tax obligations107,383132,840180,19078,200
Provision for income taxb104,100128,133148,50075,000
Currently payable income taxi
Federal40,70092,12873,16718,000
State7,40010,28014,4665,000
Average
Tax actually paid a % of gross
revenue2.24.42.21.1 2.5d
Tax actually paid a % of net
income20.635.522.313.5 24.1
Tax actually paid am % of statutory
rate44.877.148.629.4 52.4
Tax actually paid as % of provision
for taxes shown in annual report
to shareholders
46.2 80.0 58.9 30.7 57.3
recalculated simply a 46 percent of the net income figure reported to shareholders. The effective tax rate (i.e.,
the actual tax. obligation for federal corporate income taxes) ha been slightly less because of the adjustments for
amortization of investment tax credits, credit for state and local taxes paid, and so forth. According to the Federation
of American Hospitals, the elective tax rate for the six largest investor wed hospital companies in 1983 averaged
42.2 percent (Sam. uel MitchelL Director of Research Federation Of American ~Acnit~lc nd~rcr~n^] ~mm~l^;^
1985).
-7 ~ran ~ Rae I
°The tax liability actually reported to shareholders in the annual report (net of investment tax credit and state
tax credit).
CThe taxes actually paid. These taxes are based on taxable income a reported to the Internal Revenue Service
(IRS). Such taxable income usually deviates significantly from taxable income as reported to shareholders. Typically
the income figure reported to the IRS has been lower than that reported to shareholders.
dThe Federation of American Hospitals reports that local property taxes for all for-profit general hospitals (chain
and independent) totaled $99 million in 1983, a figure equivalent to 0.7 percent of gross patient revenues (Samuel
Mitchell, personal communication, 19851. If this average is applicable to the four companies included in the table,
the amount of taxes actually paid as a percentage of gross revenues would increase to 3.2 percent.
SOURCE: Data prepared from company financial reports by Steven C. Renn of He Johns Hopkins University
Center for Hospital Finance and Management (19859.
OCR for page 54
54
the firm must acljust the reporter! net profit
figure shown in that statement as follows:
· For those years in which taxes reported
to shareholders (T) are higher than those
actually paid (X), the difference (T - X)
must be acided back to book income as a
reported expense not requiring the payment
of cash.
· For those years in which taxes reporter]
to shareholders (T) are below those actually
patch (X), the difference (T - X) must be
subtracted from reported net income as a
cash outflow not booker! as an expense in
deriving the income figure.
In the literature and in the clebate on for-
profit hospitals, deferred taxes are often
viewer] as a "source of hacks," an "interest-
free loan from the government." The man-
ner in which accountants treat this item in
the flow-o£funds statement reinforces that
interpretation. The example in Note 6 should
make clear that this interpretation is based
on a strong implicit assumption, namely, that
the proper tax the firm ought to pay in a
given year is the amount it reported as an
allowance for taxes in its report to stock-
holders. With that assumption as a baseline,
"deferred taxes" might be viewed as an in-
terest-free loan. For a firm whose mvest-
ment outlays on depreciable assets grow from
year to year, clearly the balance outstanding
on these interest-free government loans
wouIc] grow over time, because in any given
year more tax wouIc! be deferred than re
.
panic ..
On the other hancI, one could take the
view that through its legislative represen-
tatives, the people have amended the social
contract between society and for-profit cor-
porati~ons and defined as the tax properly
payable that amount calculated under the
accelerated cost recovery (ACRS) deprecia-
tion system. After ad, if that is not the proper
tax, why legislate it? With ACRS taxes as
the proper baseline, the item "deferred tax
liability" is not really a source of funds and
certainly is not an interest-free government
FOR-PROFIT ENTERPRISE IN HEALTH CARE
loan. The item appears on the firm's balance
sheet only because accountants prefer to re-
port smooth, straight-line depreciation and
income tax figures to their shareholders,
which gives rise to an accounting discrep-
ancy between taxes reported to sharehold-
ers and taxes already paid. Indeed, the item
could be made to disappear from the firm's
balance sheet and flow-of-finds statement
by the simple expedient of reporting to
shareholders the same depreciation and tax
figures that are required by law.
One additional point emerges from Me
preceding discussion. In any discussion on
the income taxes paid by for-profit corpo-
rations, a clear distinction must always be
made between the taxes these corporations
show as having been paid in their annual
reports to stockholders and the taxes they
actually did pay. Otherwise the wrong
impression may be conveyed. In this con-
nection, the reader is referred once more
to Table 3.5.
Thus, in any given year the "profits" re-
ported by for-profit providers, or the anal
`` r ,,
ogous excess ot revenues over expenses
reported by not-for-profit providers, uIlder-
state the investable funds made available
through operations. That amount includes
the year's amortization of depreciable assets
on the balance sheet and, for for-profits, de-
ferred taxes.
Trends in Sources of Financial Capital
Although no comprehensive source of data
on sources of capital funds is available, data
on funding for hospital construction provide
a substantial part of the picture. As Table
3.6 and Figure 3.1 show, a remarkable change
in sources of capital for hospital construction
has taken place since the late 1960s. Phi-
lanthropy and governmental grants and ap-
propriations have declined markedly as a
source of fiends for hospital construction, and
by the early 1980s, debt (a form of investor
financing) accounted for 70 percent of such
Finds. Table 3.6 and Figure 3.1 actually un
OCR for page 55
FINANCIAL CAPITAL AND GROWTH TRENDS
TABLE 3.6 Trends in Funding for Hospi-
tal Construction, 197~1981 (percent of
total Finning
1968 1973 1978 1981
Governmental grants
and appropmabons
Copy
Hospital reserves
Debt
23 21
21 10
16 15
38 54
16
12
6 4
17 15
61 69
_ . .
aReserves include past surpluses, Ended deprecia-
don, proceeds Dom sales of replaced assets and, for
investor~wned facilities, equity paid in by investors.
SOURCE: AHA Survey of Sources of Funding for
Hospital Construction (Charhut, 1984~.
derstate the trend, because they include data
on all construction that was under way in
the years shown. If attention is confined to
projects begun in 1981, the pattern is even
more dramatic: debt was the source of 76
percent of the Finding, and philanthropy
and governmental grants and appropriations
combined accounted for less than 8 percent
(Metz, 1983~.
Approximately 80 percent of the debt fi-
nanc~g ~ 1981 was through tax-exempt
bonds, with taxable public offerings (4 per-
cent), government-sponsored lending pro
~oo
80
' 60
i
ILL
~ 40
LL
20
o
55
grams (4 percent), mortgages with
commercial banks (5 percent), and private
placements (6 percent) accounting for the
remainder (Metz, 1983). A small irony in
the financing of hospital construction is that
for-profit lenders (e.g., banks, insurance
companies, investment companies) are at-
tracted to the tax-exempt debt of not-for-
profit hospitals (the lower interest rates on
such bonds are compensated for by taxes not
having to be paid on the income), while the
taxable debt of the investor-owned compa-
nies is more attractive to tax-exempt entities
(e.g., pension Finds).
Private financing of hospital capital through
the hospital's own revenues and through
investor financing (debt or equity) parallels
the ownership of hospitals in the United
States, which also is predominantly private.
However, it should not be forgotten that this
pattern of ownership and financing is unique
among industrialized nations (see Table 3.7
for a summary of hospital ownership and
financing in several countries) and that our
heavy reliance on investor financing has un-
deniable social and economic consequences.
It may, for example, lead to more expen-
sively equipped hospitals. If, however, gov-
ernment does not wish to use its fax revenues
_ Tax-Exempt Bonds
EM Taxable Debt
abbe
....
.....
::::::::::
....
1973 1974 1975 1976 1977 1978 1979 1980 1981 t982 1983
.....
:::::
:::::::::
....
_
, -.~;=
::::::::::]
:::::'
. ....
:::::::::
·:~: :~:
:::::
Internal Funds
Government Funds
F.~ .'4
i
t~ ~
i::::<
1
=| Philanthropy
YEAR
FIGURE 3.1 Sources of capital as percentages of hospital construction funding, 1973-1983. Source: Cohodes and
Kinkead (1984).
OCR for page 56
~6
FOR-PROFIT ENTERPRISE IN HEALTH CARE
TABLE 3.7 A Synopsis of Hospital Financing in Selected Countries
Ownership of
Country Hospitals
Basis of Reimbursement for
Capital Costs Operating Costs
Role of Health
Sector Planning
The hospital sector is
subject to planning
by the provincial
government. The
capacity of the
system is fully
determined by the
provincial
governments.
The central
government's
National Health
Service develops the
nation's health plan
on the basis of
consultation with
local health officers
and local
Canada Hospitals are
predominantly
owned by lay
boards of
trustees or by
communities
United
Kingdom
France
Separate capital
budgets are granted
upon specific
approval of proposed
investments by the
· 1
provmc~a1
governments
Hospitals are
owned by the
central
Separate capital
budgets are
controlled by the
government's central government
National Health through its National
Service Health Service
About 70% of all
hospital beds
are publicly
owned (mainly
by local
governments);
the rest are
privately owned
Netherlands Hospitals are
owned by local
communities or
lay boards of
trustees
Sweden
Annual prospective
global budgets
controlled by the
provincial
governments
Annual prospective
global budgets
controlled by the
National Health
Service (i.e., the
central government)
Capital costs are Prospective per diems
and prospectively set
charges for particular
services; these per
diems and charges
are government
controlled
recovered in part
through amortization
allowances in the per
diems and charges;
the balance of costs
is financed through
subsidies from the
central and local
governments
Until 1983, the per
diems included
amortization of
capital costs; since
1983, hospitals are
reimbursed for
capital costs via
separately controlled
line items in the
budget
Hospitals are
owned and
operated by
local community
councils councils
Community-financed,
by means of specific
appropriations voted
by the community
Annual budgets
controlled by the
local community
councils
governments.
Because the National
Health Service owns
all but the few
private hospitals, the
central government
fully determines the
capacity of the
hospital system.
The hospital sector is
subject to regional
and national
planning. The
central government,
through its health
plan, determines the
capacity of the
hospital system.
Until 1983, by
Construction of
negotiated per Stems facilities and
and charges; since
1984, by annual
global budgets. The
system is still in a
state of transition
acquisition of major
medical equipment
requires a
government-issued
license, which is
issued on the basis
of regional and
national health-
sector planning.
The capacity of the
hospital sector is
planned and
controlled at the
community level.
OCR for page 57
FINANCIAL CAPITAL AND GROWTH TRENDS
TABLE 3.7 Continued
57
Basis of Reimbursement for
Ownership of
Country Hospitals
Role of lIealth
Capital Costs Operating Costs Sector Planning
Finland
West
Germany
Hospitals are
owned and
operated by
local
.~.
communlues
Hospitals are
owned by local
communities, by
1-
re~ ous
foundations, or
by private
individuals
(usually
physicans)
There is no coronal
national health plan.
Specific appropriations; Annual budgets There is a system of
financed in part by determined by a national health
the communities and system of national planning ultimately
in part by central health planning and controlled by the
government subsidy ultimately controlled central government.
by central A system of central
government government
subsidies effectively
controls the capacity
of the hospital
system.
Prospective, hospital- Capital investments are
specific, all-inclusive approved and
per diems negotiated financed by the state
between the hospital governments on the
and regional basis of statewide
associations of hospital planning.
sickness funds; these The state
rates are subject to governments
approval by the state therefore control the
governments capacity of He
hospital system.
Financed by He
federal and state
governments
through lump sum
grants (for short-
lived equipment) or
upon specific
application (for
structures or long-
lived equipment)
SOURCE: Reinhardt (1984:25A).
to supply financial capital to the health care
sector, as appears to be the case, Americans
must realize that the health care sector will
increasingly conform to the performance e~f-
pectations of the financial markets, which
are interested in the rendering of services
to humankind only insofar as such services
yield cash revenues. Whether for-profit and
not-for-profit health care organizations will
respond to these pressures in the same way
is an empirical question to which much of
this report is devoted. The questions that
we will address here are how similar are
they in their sources of financial capital, and
what is the significance of their differences
in this regard.
Relationship of Ownership to Sources
of Capital
Although it might be expected that gov-
ernment-owned health care organizations
would obtain financial capital from tax rev-
enues, that not-for-profit organizations would
obtain capital from philanthropy, and that
for-profit organizations would obtain capital
from investors, the picture is more compli-
cated. The type of ownership of health care
organizations does have important implica-
tions for the sources of capital to which they
have access, but data from hospitals show
that all types are heavily dependent on cash
reserves and debt. Figures 3.2, 3.3, and 3.4
show sources of financial capital for con-
struction of hospitals by different ownership
types. Philanthropy has become a very small
part of the picture and is largely confirmed
to not-for-profit and public hospitals. Gov-
ernmental capital grants are a part of the
picture only for public institutions. In both
not-for-profit and for-profit institutions, re-
tained earnings are a major source of capital
(this makes up a substantial portion of the
OCR for page 63
FINANCIAL CAPITAL AND GROWTH TRENDS
almost half of which were directly passed
through to governmental programs such as
Medicare.
A second advantage is the ability of not-
for-profit organizations to attract funds
through philanthropy; a third is their ex-
emption from income and property taxes,9
an advantage that is reduced somewhat by
provisions that allow for-profit organizations
to defer certain taxes.
Although the imagery of a level playing
field in a competitive environment has su-
perficial appeal, it does not appear to be a
sensible goal for public policy. Part of the
difficulty lies in devising a practical defini-
tion of a level playing field.
First, a level playing field between for-
profit and not-for-profit health care organi-
zations would require that competitors pro-
cure resource inputs, including financial
capital, in the same markets and on the same
terms (i.e., at the same prices for given
quantities). However, by definition, policy,
and practice, there are significant differ-
ences in this regard. Also, a level playing
field would require, inter aTia, similar in-
centives and burdens in the tax code. Again,
the departure from this condition is virtually
definitional. A level playing field would pre-
sumably require that both forms of provid-
ers sell their outputs in the same market,
to identical sets of potential patients, on
identical terms. But data on geographic To-
cations suffice to show that, although there
are many examples of direct competition in
the same market, there are many locales and
areas of the country that are served only by
public and not-for-profit hospitals (Watt et
al., 1986; see also Chapter 2 of this report).
A level playing field would presumably re-
quire that competitors be expected by so-
ciety and permitted by law to pursue the
same objective or set of objectives. Whether
this condition generally holds between for-
profit and not-for-profit hospitals is, at the
very least, debatable; there continue to be
many not-for-profit (and public) hospitals that
63
clearly pursue missions that have little to do
with profitability.
The conditions that would level the play-
ing field are stringent, and they involve more
than one dimension. If all but one of the
conditions are met, it could be meaningful
to assess what the implications of that one
violation would be for the level playing field.
one could even suggest policy actions to
level the field. If, however, more than one
condition is violated, that assessment be-
comes very complex and, inevitably, judg-
mental. Each form has advantages that are
incommensurate with the other's advan-
tages.
Second, there are more pressing policy
concerns than whether the advantages and
disadvantages of the two forms balance each
other. The question of what is expected of
institutions in exchange for the benefits of
tax exemptions is important of itself, on its
own terms. Similarly, the question of what
to do to assure the survival of institutions
that genuinely provide services that would
otherwise have to be provided by the gov-
ernment is also important on its own terms.
Likewise, the question of whether tax-ex-
empt bond funding should continue to be
available to not-for-profit hospitals is best
considered in terms of the impact on the
ability of these institutions to filifill or con-
tinue a mission of community service and
quality health care. In neither case is the
answer illuminated in any important way by
level playing field arguments.
Third, there is no particular reason why
the goal of policy should be equivalence in
treatment by the government rather than a
substantive goal such as to assure that ser-
vices of acceptable quality are available to
all who need them.
The major circumstance in which ques-
tions of a level playing field might gain im-
portance is if the advantages and
disadvantages conveyed on the different
forms affected their ability to survive. If gov-
ernmental policy were such that the exis
OCR for page 64
64
fence of well-run hospitals of one type or
another were threatened because of that
policy, that would be a matter of concern.
As discussed in the concluding chapter of
this report, this committee believes that at
this time a significant degree of diversity in
ownership of health care institutions has
positive aspects.
POLICY ISSUES REGARDING CAPIT~
Two major policy issues are of immediate
importance. The first concerns how capital
costs will be paid by Medicare now that it
has begun to pay all other costs on a per-
case basis. The second concerns the contin-
ued availability of tax-free bond Finding. The
committee's discussions of these very com-
plex issues led to several general conclu-
sions.
First, the committee concluded that it is
essential that Medicare continue to meet its
obligations of paying for the cost of procur-
ing capital for health care. Although the low
occupancy rates among hospitals certainly
support an argument that there is surplus
capacity in the system, many of the changes
that are needed in health care will require
additional infusions of capital into the health
care sector. Among these changes are the
emergence of new technologies, new types
of services, and types of care that are in short
supply in selective areas (home care, ex-
tended care, alcohol treatment, rehabilita-
tion services, and so forth).
The committee agrees that the method
by which capital expenses have traditionally
been paid by Medicare must be changed,
so that capital costs are included in the pro-
spectively set DRG rates. Under a pro-
spective payment system the committee sees
no justification for differential payments (e.g.,
for return on equity) on the basis offor-profit
or not-for-profit status.
The change in methods of paying for cap-
ital should not be the occasion, however, to
starve institutions. Among other effects, such
a policy would be likely to change signih
FOR-PROFIT ENTERPRISE IN HEALTH CARE
cantly the current balance between the for-
profit and not-for-profit sectors. Some evi-
dence presented in Chapter 4 and Chapter
5 suggests that for-profit providers respond
more closely to economic incentives, im-
plying that their response to such circum-
stances might be to reduce services more
quickly, to introduce more differential pric-
ing (particularly in multi-institutional sys-
tems that have institutions in different
markets), and to take other steps to protect
and enhance their capital. The committee
is concerned that not-for-profit institutions
might be more likely to avoid hard choices
that are seen as inconsistent with their mis-
sion (such as reducing indigent care) by
spending reserves that are needed to fiend
future capital improvements, thereby sig-
nificantly weakening themselves in an in-
creasingly competitive environment. The
alternative of institutions' abandoning tra-
ditional missions would be equally unfor-
tunate.
If in view of the widespread excess ca-
pacity in the hospital sector the government
decides to constrain the flow of funds that
allow capital fo`~ation in this sector, mech-
anisms should be created for establishing
exceptions in situations of merit (e.g., ter-
tiary care institutions with high costs for
technology and specialized personnel, vital
training centers committed to health profes-
sional education, institutions with a high in-
digent care burden, and so forth).
Finally, regarding tax-exempt bonds, it
must be recognized that in recent years this
has been a key source of outside capital for
the not-for-profit sector and that it provides
a vehicle for malting capital available to many
institutions that otherwise would have no
chance to obtain it (Cohodes and Kinkead,
1984~. Fulthermore, some institutions in Me
not-for-profit sector might in desperation be
tempted to change to for-profit or simply to
sell out to investor-owned companies. Thus,
governmental policy in this area affects not
only governmental revenues-the term in
which the debate is often framed but it
OCR for page 65
FINANCIAL CAPITAL AND GROWTH TRENDS
also affects the balance between the for-profit
and not-for-profit sectors. It would be very
unwise to do away with such an important
mechanism without much greater study of
the possible impact on the for-profit/not-for-
profit composition of the hospital sector. Ibe
committee strongly believes in the impor-
tance of a not-for-profit sector in health care,
and that it is imperative that tax-exempt fi-
nancing be maintained. However, it would
be appropriate to review the requirements
of eligibility for tax-exempt debt to make
more certain that institutions that obtain ap-
proval for tax-exempt bonds will serve a
public purpose regarding those unable to
pay, services that are not profitable, and
education and research.
CONCLUSION
The much misunderstood topic of capital
is key to the future for-profit/not-for-profit
composition of health care. Although a level
playing field is itself not an important goal
for health policy, eliminating not-for-profit
access to tax-exempt funding could have a
devastating effect on that particular sector.
Changes are needed in Medicare policies
for paying for expenses, including the past
practice of paying for-profit institutions a
separate return-on-equity payment. Be-
cause of foreseeable changes in different
sectors' access to capital, significant changes
in the overall composition of health care could
result inadvertently from federal policies, a
factor that should be included with other
capital-related policy questions to be con-
sidered.
NOTES
Recent reports on capital include the American
Hospital Association's Report of the Special Committee
on Equity of Payment for Not-for-Profit and Investor-
Owned Hospitals (1983), the American Health Plan-
ning Association's Report of the Commission on Capital
Policy (1984), the Healthcare Financial Management
Association's 'proposed Method of Medicare Payment
for Hospital Capital-Related Costs" (1983), We Na
65
tional Committee for Quality Health Care's "Proposed
Method for Incorporating Capital-Related Costs Within
the Medicare Prospective Payment System" (1984), and
a series of very useful reports and studies by consulting
firms and scholars done for the Office of the Assistant
Secretary for Planning and Evaluation, DHHS, in 1983
and 1984.
2The term "financial capital" stands in distinction to
"physical capital"- which refers to facilities, equip-
ment, and other physical assets that are acquired through
the use of financial capital- and "human capital," the
employees who make the organization work and in whom
the organization has invested.
3Laypersons not familiar with either accounting or
corporation finance frequently think only of equip-
ment, structures, and land when they speak of"capi-
tal." However, a firm's capital includes the sum total
of the monetary value of all of its assets, both current
and long-lived. In 1984, for example, the current assets
of the Harvard Community Health Plan accounted for
32 percent of its total asset base; the corresponding
figure for Humana, Inc., was 23 percent.
4Arguments have been made in recent years that
not-for-profit institutions have the same need for re-
turn-on-equity payments as do for-profit institutions
and that Medicare's movement to a prospective pricing
system removes any justification for differences in pay-
ments based on differences in type of ownership. (See
HFMA, 1980; AHA, 1983; and Conrad, 1984~. For the
history of the return-on-equity issue, see Somers and
Somers (1967), Feder (1977) and Kinkead (1984~.
5The estimate of $200 million in return-on-equity
payments was provided to the committee in personal
communications from Randy Teach of the Office of the
Assistant Secretary, DHHS, July 10, 1985, and from
Samuel Mitchell, director of research at the Federation
of American Hospitals, July 1985. Mr. Mitchell pro-
vided the estimate of return-on-equity's percentage of
Medicare capital to investor-owned hospitals, based on
FAH survey data that showed depreciation and interest
expenses totaling $881 million in 1983 (FAH, 1983),
and the estimate that Medicare payments constituted
approximately 3~38 percent of payments to investor-
owned hospitals.
6To illustrate, suppose that, at the beginning of fiscal
1983, a firm had purchased for $1 million an asset with
an estimated use-life of five years and a zero salvage
value at the end of that use-life. In its reports to share-
holders the firm would probably deduct from revenues
straight-line depreciation expenses equal to $1 million/
5 years, or $200,000 per year in fiscal years 1983 1987.
Furtherlllore, in its reports to shareholders it would
show that it had paid income taxes on the net income
calculated with these flat, straight-line depreciation fig-
ures.
Under the accelerated cost recovery system (ACRS)
legislated in 1981, however, the firm actually would
OCR for page 66
66
be able to depreciate the asset over only three years
for purposes of calculating taxable income to be re-
ported to the Internal Revenue Service (IRS). The an-
nual tax-deductible depreciation expense would be
$250,000 for 1983, $380,000 for 1984, and $370,000 for
1985. During these three years, then, the taxes the
firm showed as having been paid in its report to share-
holders would exceed the truces it actually paid. This
divergence gives rise to the so-called "deferred income
taxes due" shown as a liability on the firings balance
sheet. Accountants Heat this expense as a liability be-
cause in years 1986 and 1987 the firm would still book
$200,000 a year in depreciation expenses in its report
to shareholders, but would book no depreciation ex-
pense at all (on this asset) in calculating its taxable
income for the IRS. In other words, other things being
equal, the firm would report lower income taxes to its
shareholders in 1986 and 1987 than it actually paid
during those years.
7For example, a recent survey by the National As-
sociation for Hospital Development of its members (in-
dividuals with fund-raising responsibilities in hospitals)
found that the hospitals surveyed had budgeted 0.9
percent of their overall budgets for development pur-
poses and that they were planning to devote 1.4 per-
cent of their budgets to this purpose in 1985 (AAFRC,
1985~.
81hese constraints typically include appointing a
trustee (usually a bank) to monitor economic perfor-
mance and to take appropriate actions on behalf of the
bondholders, including talking possession of the hos-
pital on behalf of the bondholders in the event of de-
fault; agreeing to set rates and charges to provide
sufficient income for debt service; agreeing to maintain
the corporate existence of the hospital and to give the
trustee veto power over any substantial disposition of
assets or any merger with another institution; and op-
erating the institution to meet various indicators of
financial performance and status (e.g., debt-to-equity
ratios).
9Data published by the American Hospital Associ-
ation (1984) show Me total revenues of community not-
for-profit hospitals In 1983 to be $89,462,795 and total
expenses to be $85,637,108. Had this income of
$3,825,787 been taxed at the average effective tax rate
for the six largest investor-owned hospital companies
(42.2 percent), their federal income tax liability would
have been just over $1.6 billion; had they been taxed
at the rate actually paid by the four largest investor-
owned firms (24.1 percent; see Table 3.5), they would
have had to pay $922 million. In either case, the ex-
emp~on Dom federal income taxes was very valuable
to the not-for-profit hospital sector.
REFERENCES
American Association of Fund Raising Counsel, Iliac.
(AAFRC) (1985) Giving USA: A Compilation of Facts
FOR-PROFIT ENTERPRISE IN HEALTH CARE
and Trends on American Philanthropy for the Year
1984. New York: American Association of Fund Raising
Counsel, Inc.
American Hospital Association (1983) Report of the
Special Committee on Equity of Payment for Not-for-
Profit and Investor-Owned Hospitals. Chicago, Ill.:
American Hospital Association.
American Hospital Association (1984) Hospital So-
lutions 1984. Chicago, Ill.: American Hospital As-
sociation
Booz, Allen & Hamilton (1982) Historical Linkages
Between Selected Hospital Characteristics and Bond
Ratings. Appendix to Report of the Special Committee
on Equity of Payment for Not-for-Prof t and Investor-
Oumed Hospitals. Chicago, Ill.: American Hospital As-
sociation.
Charhut, Maureen M. (1984) Trends in Hospital Phi-
lanthropy. Hospitals 58(March 16~:70-74.
Cohen, Harold A., and Jack C. Keane (1984) Ap-
proaches to Setting the Level of Payment. Hospital
Capital Finance Background Paper prepared for Assis-
tant Secretary for Planning and Evaluation, DHHS.
Washington, D. C.: Department of Health and Human
~ .
services.
Cohodes, Donald R., and Brian M. Kinkead (1984)
Hospital Capital Formation in the 1980s. Baltimore,
Md.: Johns Hopkins University Press.
Conrad, Douglas A. (1984) Return on Equity to Not-
for-profit Hospitals: Theory and Implementation. He~kh
Services Research l9(April):41-63.
Executive Office of the President, Office of Man-
agement and Budget (1985) Budget of the United States
Government, FY 1986. Special Analysis G. Tax-Ex-
penditures, Table G-2 (Revenue Loss Estimates for Tax
Expenditures by Functions), p. G46.
Feder, Judith M. (1977) Medicare: The Politics of
Federal Hospital Insurance. Lexington, Mass.: D. C.
Heath.
Federation of American Hospitals (1983) Statistical
Profile of the Investor-Owned Hospital Industry, 1983.
Washington, D.C.: Federation of American Hospitals.
Harvard Community Health Plan, Inc. (1984) An-
nual Report. Boston, Mass.
Hernandez, Michael D., and ArthurJ. Henkel (1982)
Need for Capital May Squeeze Freestanding Institu-
tions into Multi-institutional Arrangements. Hospitals
56(M arch 1~:75-77.
Hospital Financial Management Association (1980)
Hospital Financial Management Association Principles
and Practices Board, Statement 3. Hospital Financial
Management 34:50-59.
Humana, Inc. (1984) Annual Report. Louisville, Ky.
ICF Incorporated (1983) Assessment of Recent Es-
timates of Hosed Capital Requirements. Contract study
done for Assistant Secretary for Planning and Evalua-
tion, DHHS. Washington, D.C.: ICF Incorporated.
Kinkead, Brian (1984) Historical Trends in Hospital
Capital Investment. Report prepared for the Assistant
OCR for page 67
FINANCIAL CAPITAL AND GROWTH TRENDS
Secretary for Planning and Evaluation, DHHS. Wash-
ington, D.C.: Department of Health and Human Ser-
vices. ~
Lefton, Doug (1985) Will For-Profit Hospital Chains
Swallow Up Nonprofit Sector? American Medical News
(June 18/July 5):1, 35, 37.
Metz, Maureen (1983) Trends in Sources of Capital
in the Hospital Industry. Appendix D to the Report of
the Special Committee on Equity of Payment for Nof-
for-Prof t and Investor-Owned Hospitals. Chicago, Ill.:
American Hospital Association.
National Medical Enterprises (1984) Annual Report.
Los Angeles, Calif.
Reinhardt, Uwe (1984) Financing the Hospital: The
Experience Abroad. Washington, D.C.: Department
of Health and Human Services.
APPENDIX TO CHAPTER 3
67
Schlesinger, Mark J. (1985) Review of Cohodes and
Kinkead, Hospital Capital Formation in the 1980s. The
New England Journal of Medicine 312:323.
Somers, Herman M., and Anne R. Somers (1967)
Medicare and the Hospitals: Issues and Prospects.
Washington, D. C.: The Bookings Institution, 1961.
Watt, J. Michael, Steven C. Renn, James S. Hahn,
Robert A. Derzon, and Carl J. Schramm (1986) The
Ejects of Ownership and Multihospital System Mem-
bership on Hospital Functional Strategies and Eco-
nomic Perfonnance. This volume.
Wilson, Glenn, Cecil Sheps, and Thomas R. Oliver
(1982) Effects of Hospital Revenue Bonds on Hospital
Planning and Revenue. The New England Journal of
Medicine 307(December 2~:142~1430.
The Nature of Equity F'nanc~g
Uwe Reinhardt
Equity financing is a topic about which mis-
conceptions exist, such as the beliefthat equity
capital is a cheap and plentiful source of fiends.
Although access to equity capital has signifi-
cant advantages, these advantages are less than
often supposed. These points become clear if
the topic is examined carefully.
To understand the nature of equity financ-
ing, it is best to think of an investor-owned
firm as a separate entity with a life of its own,
apart from that of its owners the sharehold-
ers. From that perspective the owners then
become just another source offinancial capital.
They are individuals or institutions willing to
supply the firm with funds against what one
might call a veritable "hope-and-prayer" pa-
per, the common-stock certificate.
A debt instrument typically obliges the firm
to pay coupon interest at stated intervals and
to redeem the instrument, at face value, at a
specified date of maturity. Failure on the part
ofthe firm to meet these commitments invokes
the risk of foreclosure by the holders of the
debt instrument. By contrast a common-stock
certificate merely promises its holder that cash
dividends may be paid at certain intervals if
there are sufficient earnings to finance these
dividends and if management and the owners'
elected representatives the firm's board of
directors decide to pay such dividends. Fur-
thermore, there is no promise whatsoever to
repay the shareholders' original investment in
the stock certificate at any time other than at
liquidation of the firm, and even then the
investor is promised only a pro rata share in
whatever is left over after all of the firm's assets
have been sold and all of its creditors have
been paid.
From the perspective of a shareholder the
purchase of a firm's common-stock certificate
is thus truly an act of faith in the integrity of
the firm's management. As the daily drama
surrounding corporate takeovers amply dem-
onstrates, management makes light of this act
of faith at its own peril. It may well be true
that in years past prior to the 1970s the
ownership of American corporations was so
diffuse that corporate managements could ride
roughshod over their firms' shareholders. In
the meantime, however, an ever-increasing
proportion of corporate stock is being held by
large institutional investors, including the
managers of pension funds. These institutional
investors are under strong pressure from their
clients to produce high rates of return on the
finds entrusted to them. They transmit this
OCR for page 68
68
pressure explicitly to the corporations whose
stock they hold, and they have shown no hes-
itation to throw managements that have dis-
appointed them to the mercies of corporate
rmders.
In soliciting funds from potential investors
against newly issued common-stock certifi-
cates, the Drm's management must convince
these investors that their investment will ul-
timately earn a rate of return that compensates
them for (a) the returns forgone by exchanging
their funds against the stock certificates rather
than by investing them in gilt-edged corporate
or government bonds and (b) the uncertainty
inherent in the acquisition of the "hope-and-
prayer" certificates. The sum of these two
components the opportunity cost of fiends and
the risk premium is referred to in the lit-
erature as the cost of equity financing. It is
the minimum rate of return that the firm must
achieve for its shareholders to keep the latter
whole, so to speak. The nature of this cost can
be illustrated with the aid of a few stylized
illustrations.
Suppose the ABC Corporation sold newly
issued common-stock certificates to investors,
with the implied or explicitly stated promise
(made by way of an accompanying prospectus)
to pay holders of Me certificates an annual cash
dividend of $6 per share for the indefinite fu-
ture. For the moment it is convenient to as-
sume that this dividend exhausts the firm's net
aRer-tax income, that is, that the firm does not
retain any income atal1. If investors could earn
an annual rate of return of, say, 10 percent on
relatively safe corporate or government bonds,
they probably would require an expected an-
nual rate of return of at least 15 percent against
ABC Corporation s common-stock certificates.
Thus, they would pay ABC $40 at most for
such a certificate, since art annual return of $6
is exactly 15 percent of $40. The price of $40
per share can also be referred to as the pres-
ent, discounted value of the future dividend
stream, which is calculated as the sum
p$6.00 $6.00
1.15 1.152
+ $6.00
1.153
$6.00
0.15
= $40.00
=
=
FOR-PROFIT ENTERPRISE IN HEALTH CARE
If management strives to live up to the
promises it made when first marketing the stock
issue, it must earn sufficient revenues to cover
all production costs (such as wages and the cost
of raw materials, energy, and other inputs), all
interest on debt, and all taxes and still leave
a sufficiently large residual to finance the pay-
ment of an annual cash dividend of $6 per
share to shareholders. Although modern ac-
counting rules would define the $6 as part of
corporate "profits," from this firm's perspec-
tive that dividend actually can be viewed as a
cost of procuring the equity funds that sustain
the corporation's activities. The annual divi-
dend is a cost of financing in this sense. It is
the analogue of interest on debt. In our ex-
ample this cost of equity financing can be ex-
pressed as $6 per year per $40 of equity
financing, or simply, as 15 percent per year.
By contrast, if the firm had raised $40 of fi-
nancing by selling newly issued bonds that pay
bondholders an annual coupon-interest rate of,
say, 10 percent, and if the firm faced a profit
tax of 46 percent, then its annual after-tax cost
of debt financing would be only (1-
0.46~0.10~$40 = $2.16 per $40 of debt fi-
nancing, or 5.4 percent per year. Clearly, then,
from the firm's point of view, the cost of debt
financing would be much lower than the cost
of equity financing. On an aPcer-tax basis it
would be only about one-third as high (pre-
cisely the opposite of the erroneous conclusion
reacher} in Chapter 3 in connection with the
financing of Humana, Inc.~.
What would happen if the hypothetical ABC
Corporation ultimately failed to deliver the
promised dividend of $6 per share? Could it
do so with impunity? Suppose, for example,
that shortly after the sale ofthe new stock issue
an apologetic management of the ABC Cor-
poration issued a revised dividend forecast of
only $4.50 per share for the indefinite future.
Under the revised forecast, investors seeking
to earn at least 15 percent per year on in-
vestments of this kind would then pay only
$30 per share ofthe company's stock. Investors
who originally bought We stock at $40 per share
would suffer a capital loss of $10 per share
upon reselling the shares. If they held on to
the stock, they would be earning, ex post, only
$4.50 or 11.25 percent per year on their orig-
inal investment of $40 per share.
(3.1) It may be interjected at this point that the
. . .
$6.00
1. 1Sn
OCR for page 69
FINANCIAL CAPITAL AND GROWTH TRENDS
relative cheapness of equity financing lies pre-
cisely in management's ability to breach with
impunity that is, without the threat of legal
sanction-the implicit promises made when
stock was originally sold. While the original
investors' opportunity and desired risk pre-
mium may well have been 15 percent, it may
be argued, the f~rm's cost of equity financing
ex post was only 11.25 percent. In fact, if man-
agement had wished to do so, it could have
reduced ABC Corporation's cost of equity fi-
nancing to zero simply by paying no dividends
at all. How valid is that argument?
If the persons active in the financial markets
had no memory at all, a strategy of optimistic
projections and dismal performance ex post
might, indeed, lower a corporation's cost of
equity financing permanently. The financial
markets, alas, do have a memory. In the pres-
ent example, the firm obviously could sell ad-
ditional shares of stock only at $30 per share,
and perhaps not even at that much lower a
price. Having been disappointed once, inves-
tors would be apt to increase the risk premium
demanded on investments in ABC stock. Their
minimum required rate of return might be
revised upward from 15 percent to, say, 17
percent per year. Where previously investors
were willing to pay the firm $6.67 per dollar
of projected dividend ($1/0.15>, they would
now be willing to pay only $5.88 ($1/0.17), or
$26.47 for a share promising a dividend of$4.50
per year. Shareholders suffering the implied
capital loss might be disappointed enough to
support any proxy fight seeking to oust the
incumbent management. In short, while a firm
does have the legal leeway to reduce its cost
of equity financing ex post once or twice, this
is not a viable, long-run strategy of financial
management.
So far it has been assumed that the ABC
Corporation pays out all of the firm's net in-
come in dividends. What if the firm retained
some of these earnings? Would that constitute
a costless source of funds from its point of view?
Suppose, specifically, that in 1985 the firm's
board of directors decided not to pay any div-
idend and to retain the entire $6 of earnings
per share in the firm's activities. The firm's
shareholders might go along with that decision
if they were promised additional dividends in
the future. Abstracting from the taxation of
dividends, it can be shown that management
69
would keep the shareholders whole that is,
it would maintain the market price per share-
if the earnings retained in the firm were in-
vested in assets yielding an annual return of
at least 15 percent. In other worcls, respon-
sibly used, a firm's retained earnings are not
a costless source of funds. In principle such
earnings belong to shareholders. If they are
retained in the firm, shareholders bear op-
portunity costs the returns they could have
achieved had the retained earnings been paid
to them in the form of dividends and had these
dividend proceeds then been reinvested else-
where. Although the taxation of dividends and
the cost of issuing new stock certificates com-
plicates matters somewhat in practice, at this
level of the discussion it is best to think of the
cost of a firm's retained earnings as equivalent
alto the cost of equity financing procured by the
sale of new stock certificates.
All of the preceding illustrations have as-
sumed flat annual dividends of either $6 or
$4.50 in perpetuity. In reality such a projec-
tion would be rare. More typically, corpora-
tions project and potential investors assume
that dividends per share will grow over time.
ABC Corporation had led investors to expect
not a flat annual cash dividend of $6, but a
dividend stream growing at a steady annual
growth rate of, say, 5 percent, with the first
dividend payable one year hence projected at
$4 per share. In this case potential investors
would expect a dividend of $4.20 in the second
year, $4.41 in the third, $4.63 in the fourth,
and so on. The maximum price they would
pay for one share of stock would, as before,
be calculated as the present, discounted value
of this perpetually growing dividend stream.
If investors sought, as before, to earn an annual
rate of return of 15 percent on their investment
in this stock, then the present value of the
projected perpetually growing dividend stream
can be shown to reduce to the simple expres-
sion
p= $4
0.15 - 0.05
= $40
(3.2)
As before, the firm's aPcer-tax cost of equity
capital would be 15 percent. By itselfthe change
in the time path offuture cash dividends would
not alter the firm's cost of equity capital (un-
less, of course, the change affected the risk
OCR for page 70
70
potential that investors attribute to the stock
and thus the risk premium that they demand
of investments in that stock).
The model of the perpetually growing pro-
jected dividend stream can be used to illus-
trate the role of growth in the valuation of
common stock. Let P denote the current mar-
ket price paid at the end of the current period,
D the dividend per share expected to be paid
at the end of the current period, g the growth
rate per period in dividends per share, and r
the minimum rate of return investors consider
acceptable for this type of investment. Then,
as before, we can express the current market
price per share of the stock as
Suppose one knew the current market price
(P), the first-period dividend (D), and the re-
quired rate of return (r). Then one could solve
this expression for the expected growth rate
(g) implicit in these numbers as follows:
D
g = r --
It has been shown in Chapter 3 that in 1984
Humana, Inc., paid its shareholders a divi-
dend yield (D/P) of 2 percent per year. If one
assumes that investors in Humana stock will
wish to earn an annual rate of return of at least
15 percent then, according to the model, they
must be expecting annual dividends per share
to grow at a rate of at least (r-DIP) or
(0.15 - 0.02) = 0.13 or 13 percent per year.
Although the constant, perpetual-growth model
used in this illustration may be only an ap-
proximation of the algorithm actually used by
investors to value Humana stock, the general
proposition implicit in the illustration is never-
theless valid: A corporation's shareholders will
accept a low current dividend yield only if they
are convinced that dividends per share will
grow commensurately rapidly in the future.
This proposition does not imply that an inves-
tor-owned hospital chain must pursue a high-
growth policy to survive in the financial mar-
kets. Such a firm could, after all, adopt a policy
of low growth and high-dividend yield. But it
does mean that a hospital chain with a low
current dividend yield clearly has committed
FOR-PROFIT ENTERPRISE IN HEALTH CARE
itself to a high-growth strategy. This conclu-
sion is the basis for the quite valid observation
that the nation's investor-owned hospital chains
appear to be driven by the imperative of growth
in earnings per share.
Finally, it may be thought that the preced-
ing conclusions were forced by the highly un-
realistic assumption that investors evaluate
investments in common stock on an infinite
investment horizon. Most investments in stock,
it may be argued, are made in contemplation
of the finite investment horizon of a few years,
in which case it is not the expected future
dividends but the expected future capital gains
from a resale of the stock that drive its current
market value. Would a finite investment ho-
rizon alter the insights illustrated above? They
would not.
Suppose, for the sake of simplicity, that a
potential investor in ABC Corporation stock
had an investment horizon of one year. If Pi
were the price per share at which the investor
now expects to be able to resell the stock one
year hence, D the expected first-year divi-
dend, and r the rate of return the investor
(3.4) wishes to earn on this investment, then the
current market price (PO) that investor would
be willing to pay per share of the stock would
be
_ P1 + D
(3.5)
How would investors formulate their expec-
tation of the future resale price Pi? Presum-
ably, they would put themselves into the shoes
of investors who would contemplate purchas-
ing the stock one year hence. The latter could
be expected to follow the same algorithm cur-
rently being followed by investors, with all of
the variables pushed one year further into the
fixture. By simple extension, an entire succes-
sion of such investors would eventually con-
vert the finite-horizon model into one with an
infinite stream of future dividends. In other
words, the current market price of a common
stock can be viewed as ultimately nothing more
than the discounted present value of an infinite
fixture dividend strewn.
The one-period model can also be used to
illustrate the interplay between dividend yield
and capital gains. From the expression for the
current price per share (PO) we can obtain the
OCR for page 71
FINANCIAL CAPITAL AND GROWTH TRENDS
following expression for the investor's ex-
pected annual rate of return:
D + UPS - Pn)
D + (Pi-Pi) (3.6)
o Po
i?;i~en~ capital
yield gain
Clearly, this expected rate of return is merely
the sum of the expected dividend yield and
the expected capital gain from the investment
in the stock. The two forms of return are sub-
stitutes for one another. The expected capital
gain, however, is strictly a function of expected
future dividends, as mentioned above. If there
is to be a capital gain, future dividends per
share must be expected to grow, which is, of
course, a repetition of our earlier proposition
that a corporation paying only a modest cur-
rent dividend yield has implicitly committed
itself to a high-growth strategy, and failure to
achieve ultimately the appropriate growth rate
will disappoint shareholders.
These insights may be used to reexamine
the previously cited (p. 61) assertion that an
investor-owned hospital chain could easily
translate $1 million of current annual earnings
into $25 million of additional financing, while
a not-for-profit hospital could leverage such an
earnings figure into at most $2 million of ad-
ditional financing. Such a statement betrays
either ignorance of financial markets or, if it
were valid, an astounding ignorance among
analysts in the financial markets.
In the illustration cited earlier, the $25 mil-
lion of additional financing would consist of $12
million additional debt, $12 million procured
by issuing additional common-stock certifi-
cates, and $1 million of retained earnings, the
assumption being that not a penny of the $1
million in earnings would be paid out in div-
idends. Presumably, the suppliers ofthese funds
would expect the usual "rentals" in return for
parsing with their money. These "rentals" would
consist of the annual coupon interest on the
new debt and the returns (dividend yield and
capital gains) that would have to be achieved
for the suppliers of the additional $13 million
in equity capital.
If the hospital chain's pretax cost of the debt
financing were, say, 12 percent per year, then
71
on an after-tax basis the $12 million additional
debt would imply additional coupon interest
of $1.44 million. Additional pretax net income
would have to be available to finance this ex-
pense. Furthermore, at some fixed date in the
future, the $12 million of debt would have to
be repaid. That repayment would not be a
charge against income, but the cash would have
to be available at the date of maturity.2
In addition to the extra net income that would
be required to service the $12 million of ad-
ditional debt, additional fixture earnings would
be required to compensate the suppliers of the
additional $13 million in equity financing. If
we assume that the hospital chain's sharehold-
ers would be satisfied with a relatively modest
annual rate of return of 15 percent of their
funds, then the firm would have to achieve
additional after-tax earnings of $1.95 million
per year to keep shareholders whole. To pro-
vide that level of return through dividends
would require pretax earnings of $3.61 mil-
lion, if the chain's profit tax rate were 46 per-
cent. (:~it were intended to provide Me return
maindy through capital gains, then fixture div-
idends would have to be commensurately
higher.)
Altogether, then, the additional $25 million
in financing would require additional annual
pretax net income of about $5.7 million per
year or an after-tax net income of close to $3
million per year. The average profit margin
(net after-tax income as a percentage of rev-
enue) tends to be below 10 percent in the for-
profit hospital industry. But even if one used
a profit margin as high as 10 percent, an ad-
ditional $30 million or more in extra annual
revenues would have to be yielded by the ad-
ditional $25 million of assets that were fi-
nanced with the assumed infusion of capital.
Such revenues might well be attainable with
the new assets, but the hospital chain would
have to convince the financial markets of such
a forecast. To simply point to the additional
$1 million in current earnings that have come,
after all, from assets already in place and fi-
nanced with funds raised earlier would never
convince any financial analyst worthy of that
title. Furthermore, if a not-for-profit chain could
convince financial analysts that it, too, could
translate an additional $25 million of capital
into additional annual net profits of $5.7 mil-
lion or so, then that not-for-profit chain, too,
OCR for page 72
72
would be able to procure much more than the
alleged $2 million in the financial markets. In
short, the spokesman for the investor-owned
hospital industry quoted in Chapter 3 errs rather
remarkably with his illustration. He has suc
cumbed to the myth of price-earnings-ratio
magic. The nation's financial markets are not
perfect, but they are surely not as gullible as
that spokesman seems to surmise.
The major conclusions from this discussion
of equity financing may be distilled into the
following propositions:
1. From the perspective of the firm as an
entity, equity financing is just another source
of financing requiring the firm to earn suffi
cient revenues to reward the suppliers of such
funds for parting with their money.
2. The reward the firm must offer the sup
pliers of equity funds must be sufficiently high
to compensate the suppliers for the opportu
nity cost of parting with their funds and for
the risk they assume by accepting the relative
uncertain stream of rewards implicit in com
mon-stock certificates. This minimally re
quired level of reward is the firm's cost of equity
capital.
3. Because of the uncertainty inherent in
the rewards to holders of common stock, the
cost of that financing typically is much higher
than the cost of debt financing, at least at nor
mal debt-to-equity ratios.
4. From the firm's perspective, the major
advantage of equity financing lies in the flex
ibility it offers management to phase the re
ward stream paid to shareholders over time.
Under a debt contract the reward stream is
rigidly fixed and legally enforceable. Under Sales revenue
the common-stock contract the firm (with the
approval of its board of directors) can trade off
reward payments at one time for higher re
ward payments later on.
5. In an environment dominated by insti
tutional investors in the role of shareholders,
a firm's management cannot breach with im
punity the promises made explicitly or im
plicitly to shareholders.
6. In conducting their affairs many inves
tor-owned hospital chains appear to have cho
sen low current dividend yields in exchange Equals profits
for an implicit promise of rapid growth in fu
ture earnings per share and dividends. Com
FOR-PROFIT ENTERPRISE IN HEALTH CARE
panics could, for example, pay dividends that
approximate prevailing interest rates. This
growth imperative is a deliberate managerial
choice, but not, in principle, a necessary con-
dition for survival in the for-profit hospital
market.
7. The much vaunted ability of investor-
owned chains to parlay current earnings into
high multiples of additional financing is an e2f-
aggeration based on a misperception of the
financial community.
There is the added insight that the "profits"
reported by investor-owned business fines tend
to be widely misunderstood. To illustrate this
point, let us assume that a corporation has
assets of $1 billion, that $400 million of these
assets have been financed with debt at an av-
erage pretax interest rate of 12 percent per
year, and that the rest of the financing has
come from shareholders through original con-
tributions of funds or through retained earn-
ings. If Mat firm earned an average of $0.25
of pretax net operating income for every dollar
of assets it deploys, then its income statement
for a given year could be cast as that shown in
Table 3-A. 1
From the firm's net operating income of $250
million, there would be deducted, first, its
annual coupon interest of $48 million. The re-
mainder would be the firm's taxable income.
If the firm did not avail itself of any tax loop
TABLE 3-A.1 Income Statement for a
Hypothetical Business Corporation, Fiscal
Year l9xx (millions of dollars)
Less operating expenses
Equals operating profit
Less interest on debt (12% on
$400)
Equals taxable net income
Less income taxes (46%)
Equals net income available to
shareholdersa
Less costs of equity financing
(who of $600)
$ 1,250.
(1.000.)
$ 250.
( 48.)
$ 202.
( 93.)
$ 109.
~ 90.)
$ 19.
aThe accountant's definition of"orofits."
.,
The economist's definition of"profits."
OCR for page 73
FINANCIAL CAPITAL AND GROWTH TRENDS
holes or deferrals, and if it faced a profit tax
rate of 46 percent, its aPcer-tax net income would
be $109 million. This amount would be avail-
able for distribution to shareholders or reten-
tion in Me firm on behalfofshareholders. Under
modern accounting practices the entire $109
million would be reported as the Drm's "prof
. ,,
its.
In textbooks and writings, economists differ
sharply with accountants on this point. As is
shown in Table 3-A. 1, economists would de-
fine "profits" as the residual after deduction of
the cost of equity capital Tom reported book
profits. If it is assumed, as before, that share-
holders minimally require a rate of return of
15 percent per year on fiends entrusted to the
firm under the common-stock contract, then
the economists measure of"pro~ts" would be
only $19 million, not $109 million. In other
words, economists define as profits only the
windfall gain over and above the shareholders'
required return. The latter $90 million in
73
the present example is treated simply as part
of the firm's cost of doing business.
NOTE
hat the conceptual level, one can visualize the re-
quired accumulation of cash as follows. Presumably the
firm used the additional $12 million of debt financing
to acquire $12 million of income-yielding assets. To
calculate the income from these assets, the fimn would
annually deduct an allowed depreciation expense based
on the value of the underlying assets. The annual de-
preciation expense would not require a cash outlay in
the year for which it is recognized. Rather, one can
think of this expense as a form of earmarking cash rev-
enues either for replacing the underlying assets when
they are worn out or for repaying the debt that financed
them. In other words, we imagine the firm to have
deposited the cash revenues "earmarked" through de-
preciation expense in a fund designated for the repay-
ment of debt. That repayment, then, will not be a
further charge against future income. It was charged
to income over time in the form of depreciation ex-
pense.
Representative terms from entire chapter:
net income
