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'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

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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

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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).

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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

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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.

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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

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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.

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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-ofunds 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

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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).

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~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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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,

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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."

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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.