Which of the following types of health Care Organizations recognize depreciation expense

First on most lists of factors explaining the growth of investor ownership and multi-institutional systems is ''access to capital." Although capital costs represent a relatively small proportion of health care costs (on average, approximately 7 percent of hospital costs under the Medicare program), capital expenditures (for example, for new technologies) often translate into higher operating costs. Access to capital by health care institutions is crucial not only to their own future but to the future shape and configuration of the health care system itself. Access to capital is also integral to the topic of this report, because it is affected (by definition and in practice) by whether institutions 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 discuss the factors that affect institutions' access 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 capital,1 it did examine some of the implications of the for-profit/not-for-profit distinction for capital policy in health care.

What is Capital?

Like any form of organized economic activity, health care organizations need financial capital to carry out their functions.2 Before an organization can provide services or undertake a new program, it must use financial capital to purchase or rent space, equipment, supplies, labor, and so forth—that is, to prepay for certain inputs used in the production 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 appropriations, 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). Tables 3.1 and 3.2 show the balance sheets of two health care organizations—a not-for-profit HMO (the Harvard Community Health Plan) and an investor-owned hospital company (Humana, Inc.). As the figures show, a health care provider's assets include not only real capital assets such as movable and fixed equipment, land, and buildings but also supplies, certain financial assets (cash, marketable securities, and accounts receivable), and any other form of prepayment such as prepaid interest and rent. Assets for which recovery of the prepayment through earned revenues is expected within a year are usually grouped under the heading of "current assets" or working-capital assets. Prepayments expected to be recovered through revenues earned over a longer span of time are referred to as fixed or long-lived assets. The latter consist mainly of equipment, structures, and land owned by the organization and represent a substantial (but far from the total) amount of the total financing that an organization needs in order to operate.3

TABLE 3.1

Harvard Community Health Plan, Inc., Balance Sheet, September 30, 1984.

TABLE 3.2

Humana, Inc., Consolidated Balance Sheet, August 31, 1984.

Access to financial capital is essential to any health care organization that would respond to changes in its community, acquire new technologies and replace old equipment, renovate or replace deteriorated facilities, offer new programs or new services, or make changes to improve productivity or enhance quality. Much attention has been given to the aggregate future needs for financial capital among hospitals. Estimates of such needs in the 1980s vary widely, depending on assumptions, from $100 billion to nearly $260 billion (ICF Incorporated, 1983; Cohen and Keene, 1984:24-26). Assessments of the ability of health care organizations 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 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 hospitals (or portions thereof) will need to be reconfigured; alternative sites will have to be developed for long-term care and ambulatory care; and other steps will be necessary if hospitals are to become more comprehensive health care organizations. Also, certain areas of the country have rapid population growth, and new facilities or expansions of existing hospitals may be needed.

Thus, health care institutions have and will continue to have substantial capital needs, and access to capital translates directly 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 funds received in the past)

• grants or other appropriated money from government

• funds accumulated from past operations

• the sale of short-term and long-term debt instruments

• the sale of ownership certificates (stock).

One other source available in some instances is funds from the sale of assets already owned.

Thus, whether an institution has access to financial capital depends on at least one of three things: whether it can attract philanthropy (a source that as a practical matter is not available to for-profit institutions); 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 government-owned hospitals (federal, state, or local); or whether it has earnings (or potential earnings). Earnings are not only an important source of capital, they are also crucial to an organization's ability to secure funds through borrowing or through selling shares.

Funds accumulated from business operations are, in principle, a source of financial capital that is available to any ongoing organization, regardless of ownership type. Such funds are created when an organization's annual cash revenues exceed its corresponding 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-funds statements also indicate how the funds were used in 1984. Funds accumulated from operations are shown in the first few lines of each statement, although they are labeled differently.

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.

TABLE 3.4

Humana, Inc., Consolidated Statement of Sources and Uses of Cash for the Year Ended August 31, 1984 (in thousands of dollars).

The cash revenues of investor-owned hospitals include return-on-equity payments from Medicare (and certain other third-party payers), a source of funds that is not available to the not-for-profit sector.4 The rationale of such separate return-on-equity payments is closely linked to cost-based reimbursement methods, which are now being phased out by Medicare. Interest expenses (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 chapter, suppliers of equity financing—the shareholders—supply these funds in the expectation that they will earn an appropriate rate of return on their investments. The willingness of the investors to provide such funds depends, at minimum, on their being able to expect a return on their investment 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 portrayed 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. However, under a prospective rate-setting system, as with a charge-based system, the opportunity exists for institutions to generate funds in excess of costs.

Prior to 1982, Medicare's return-on-equity allowance for investor-owned hospitals 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 return-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 38-40 percent of Medicare capital payments to investor-owned hospitals.5 With the phasing out of cost-based reimbursement, the rationale for separate return-on-equity payments to investor-owned facilities becomes much less clear. The question will undoubtedly be addressed in legislation on how Medicare should pay capital expenses in the future, a topic examined later in this chapter.

In addition to recoveries of earlier expenditures through revenues for depreciation and amortization expenses, for-profit entities commonly subtract from the 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 funds that represent the recovery 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 amortization"—are shown on the income statement

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 of revenues over expenses"—the proverbial bottom line in either case. It follows that the net profits or excess revenues shown in annual reports tend to understate significantly the funds a hospital earns from operations in any given year. To eliminate the distortion, a properly executed flow-of-funds statement therefore adds back to reported income these noncash expenses (see Figures 3.3 and 3.4).

Figure 3.3

Sources of capital as a percentage of construction funding—investor-owned hospitals. Source: Kinkead (1984). Data are from American Hospital Association's Construction Survey for various years. Values for 1970, 1971, and 1972 have been interpolated (more...)

Figure 3.4

Sources of capital as a percentage of construction funding—public hospitals. Source: Kinkead (1984). Data are from American Hospital Association's Construction Survey for various years. Values for 1970, 1971, and 1972 have been interpolated from (more...)

The current tax code provides one other source of working capital for for-profit organizations in the form of investment incentives, which allow companies to recover their investment costs more quickly by deferring a portion of their corporate income taxes. Table 3.5 shows corporate taxes paid by the four largest investor-owned hospital companies in relationship to several different financial measures. The percentage of taxes that are deferred (and that are therefore available as working capital) vary, depending primarily on the 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 statutory rate, and deferred taxes provided only a minor source of working capital ($7.4 million of almost $800 million of funds provided), as Table 3.4 shows. Deferred taxes were a more important source of funds 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, 1984).

TABLE 3.5

Income Tax Obligations and Payments of Four Investor-Owned Health Care Corporations, Fiscal Year Ending 1983 (in thousands of dollars).

In reporting the sources of "funds from operations" in its flow-of-funds statement, the firm must adjust the reported 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 added back to book income as a reported expense not requiring the payment of cash.

• For those years in which taxes reported to shareholders (T) are below those actually paid (X), the difference (T-X) must be subtracted from reported net income as a cash outflow not booked as an expense in deriving the income figure.

In the literature and in the debate on for-profit hospitals, deferred taxes are often viewed as a "source of funds," an "interest-free loan from the government." The manner in which accountants treat this item in the flow-of-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 stockholders. With that assumption as a baseline, "deferred taxes" might be viewed as an interest-free loan. For a firm whose investment outlays on depreciable assets grow from year to year, clearly the balance outstanding on these interest-free government loans would grow over time, because in any given year more tax would be deferred than repaid.

On the other hand, one could take the view that through its legislative representatives, the people have amended the social contract between society and for-profit corporations and defined as the tax properly payable that amount calculated under the accelerated cost recovery (ACRS) depreciation system. After all, 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 loan. The item appears on the firm's balance sheet only because accountants prefer to report smooth, straight-line depreciation and income tax figures to their shareholders, which gives rise to an accounting discrepancy between taxes reported to shareholders and taxes already paid. Indeed, the item could be made to disappear from the firm's balance sheet and flow-of-funds 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 the preceding discussion. In any discussion on the income taxes paid by for-profit corporations, 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 connection, the reader is referred once more to Table 3.5.

Thus, in any given year the "profits" reported by for-profit providers, or the analogous "excess of revenues over expenses" reported by not-for-profit providers, understate 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, deferred 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. Philanthropy and governmental grants and appropriations have declined markedly as a source of funds for hospital construction, and by the early 1980s, debt (a form of investor financing) accounted for 70 percent of such funds. Table 3.6 and Figure 3.1 actually understate the trend, bemuse 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 funding, and philanthropy and governmental grants and appropriations combined accounted for less than 8 percent (Metz, 1983).

TABLE 3.6

Trends in Funding for Hospital Construction, 1973-1981 (percent of total funding).

Figure 3.1

Sources of capital as percentages of hospital construction funding, 1973-1983. Source: Cohodes and Kinkead (1984).

Approximately 80 percent of the debt financing in 1981 was through tax-exempt bonds, with taxable public offerings (4 percent), government-sponsored lending programs (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 attracted 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 companies is more attractive to tax-exempt entities (e.g., pension funds).

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 undeniable social and economic consequences. It may, for example, lead to more expensively equipped hospitals. If, however, government does not wish to use its tax revenues 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 expectations 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.

TABLE 3.7

A Synopsis of Hospital Financing in Selected Countries.

Relationship of Ownership to Sources of Capital

Although it might be expected that government-owned health care organizations would obtain financial capital from tax revenues, that not-for-profit organizations would obtain capital from philanthropy, and that for-profit organizations would obtain capital from investors, the picture is more complicated. The type of ownership of health care organizations does have important implications 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 construction of hospitals by different ownership types. Philanthropy has become a very small part of the picture and is largely confined to not-for-profit and public hospitals. Governmental capital grants are a part of the picture only for public institutions. In both not-for-profit and for-profit institutions, retained earnings are a major source of capital (this makes up a substantial portion of the sector labeled ''equity" in Figure 3.3). For-profit institutions have one additional source of capital beyond the sources available to not-for-profit institutions—the equity capital from investors.

Figure 3.2

Sources of capital as a percentage of construction funding—voluntary hospitals. Source: Kinkead (1984). Data are from American Hospital Association's Construction Survey for various years. Values for 1970, 1971, and 1972 have been interpolated (more...)

Several reasons for the trends in debt financing can be identified, in addition to the obvious factor—the end of the Hill-Burton program's governmental grants. Many of the factors involve governmental policies (Cohodes and Kinkead, 1984). The Hill-Burton program itself included loan and interest subsidy programs, and the Federal Housing Administration's so-called 242 program provides mortgage insurance for both investor-owned and not-for-profit hospitals. More generally, the increasing comprehensive-ness of third-party coverage greatly increased the likelihood that hospitals could break even or earn a surplus. Recognition of capital costs by Medicare—as in the earlier Blue Cross Association/American Hospital Association Principles of Payment for Hospital Care (1963) that was the basis for subsequent public and private cost-based, third-party payments—was of key importance. Reimbursing for interest expenses provided incentives to use debt as a source of funds (taking money out of an endowment was not reimbursable), and reimbursing for depreciation expenses helped hospitals to build internal reserves that could be used as leverage in the capital market. (However, inflation and technological change meant that depreciation schedules based on original cost did not provide sufficient funding for replacement—another reason that hospitals needed to borrow, even if they had funded depreciation.) Tax-exempt debt has become the single largest source of financial capital for hospitals. Tax-exempt bonds opened up a market for small issues and made it easier to secure loans, because pledges of earnings could be used instead of the assets that commercial banks had generally required.

The Costs of Capital

Substantial costs are incurred not only in obtaining equity and debt financing, but also in obtaining governmental or philanthropic grants and contributions.7 Debt requires (and equity investments usually require) that periodic payments of interest (or dividends) be made. To all sources of capital are attached certain expectations of performance; however, the expectations tied to various sources of capital differ in some very significant ways.

Philanthropy and Governmental Grants

The expectations attached to philanthropic and governmental grants are to varying degrees explicit and detailed. The most general expectation, however, is that the recipient institution will not act as a profit-maximizing entity. Indeed, one way of looking at the costs of governmental or philanthropic grants is in terms of deviation from the profit-maximizing model—for example, rendering care to indigent patients at no cost or at a price that is lower than a theoretically profit-maximizing price. Seen in this light, funds from governmental or philanthropic grants can be very expensive to an institution, such as the so-called community service and free-care obligations that were attached to the use of Hill-Burton funds. On the other hand, however, these sources of funds enable (or require) institutions to conform to some extent with the traditional social missions of health care institutions, that is, as community, charitable, teaching, or research institutions. The marked decline in the relative magnitude of these sources of capital financing helps to explain today's uncertainty and debate about the proper mission of health care institutions.

Debt Financing

If funds are advanced in the form of debt instruments, they can be thought of as being "rented" for a specified period at a specified annual rate called interest. The specifics of the rental contract are spelled out in great detail in a bond indenture, which stipulates not only the interest rate and date of maturity on which the funds must be returned to their owners (the creditors) but also sets forth numerous additional constraints on behavior the borrowing entity must obey, lest there be foreclosure or other penalties (Wilson et al., 1982).8 Such constraints have prompted concern that the generation of cash to pay interest and to repay debt will become the hospital's first obligation, making not-for-profit hospitals with financial obligations to bondholders little different from investor-owned hospitals similarly responsible to shareholders (Wilson et al., 1982:1428).

Both the availability and the terms of debt financing depend substantially on formal assessments of creditworthiness by lenders and, when bonds are the vehicle, by rating agencies (Moody's or Standard and Poor's). Key factors include hospital location, hospital market share, the ability and skills of management, the reimbursement and regulatory environment of the state, and financial performance (Cohodes and Kinkead, 1984). Too much bad debt (above 5 percent) and too much dependency on nonoperating income (e.g., income from philanthropy, governmental appropriations, or endowments) are negative factors. Thus, one of the consequences of American hospitals' dependency on private sources of capital is that providing uncompensated care will likely harm their ability to gain access to capital.

The growing dependence on bonded indebtedness also signals an important change in the relationship between medical institutions (of all ownership types) and the communities in which they are located (Schlesinger, 1985). First, the money comes from (and the accompanying accountability is to) sources outside the community. The relationship that was established between hospital and community via fund-raising drives (e.g., to match Hill-Burton funds) has been greatly attenuated in many communities.

Second, because management depth and diversified sources of revenue reduce risk, multi-institutional systems (and their component institutions) have greater access to capital than do independent institutions (Booz, Allen & Hamilton, 1982; Hernandez and Henkel, 1982). This is true for both for-profit and not-for-profit multi-institutional systems. The advantage of multi-institutional systems can be measured in terms of their bond ratings (all other things being equal, the higher the bond rating, the lower the cost of capital), as is shown in Table 3.8 . The financial market's preference for the debt of multi-institutional systems, as opposed to the debt of independent institutions, is a key factor in the growth of multi-institutional arrangements. Whether the benefits of the options made possible by systems' access to capital outweigh the loss of local control that characterizes multi-institutional systems is subject to debate. It is clear, however, that some types of decisions migrate away from the local level when an institution becomes part of a multi-institutional arrangement. (For more on this subject see Chapter 9.) The relationship between this trend and the reliance on private capital is also clear.

TABLE 3.8

Comparative Distribution of Health Care Borrowers by Rating Category, 1978-1981.

Equity Financing

The controversy over the role that equity financing plays in directing the flow of resources into the health care sector has been fueled by a widespread lack of understanding of the legal and financial characteristics of this type of financing. Because of the importance of misconceptions about equity capital, the nature and cost of equity financing are discussed briefly here and in greater detail in the Appendix to this chapter.

It is widely believed that the earnings retained by a corporation are a costless source of funds and that financing procured by the issue of new stock certificates is cheap relative to debt financing. This inference appears to be based on the relatively low dividend yield (defined as the ratio of dividends per share to market price) on corporate stocks. In 1984, for example, Humana, Inc., paid its shareholders a dividend of $0.575 per share, which amounts to about 29 percent of its reported earnings per share for that year. The market price per share of Humana stock during 1984 fluctuated between $25.50 and $33.00. Dividends per share thus amounted to only about 2 percent of the average market price per share during that year. In the same year, the weighted average interest rate on all of Humana's long-term debt was 12 percent, or about 6.5 percent on an after-tax basis. From these numbers one might easily infer that debt financing constituted a much more expensive source of funds from Humana's viewpoint than did equity financing—about three times as expensive, to be exact.

There is the further thought, occasionally encountered in the debate on this issue, that the ability to print and sell common-stock certificates endows investor-owned hospitals with a money pump. Spokesmen for investor-owned hospitals contribute to that impression. As reported in the American Medical News, for example, at a June 1985 conference a senior vice president of the Hospital Corporation of America gave "a striking explanation of how a for-profit hospital company can raise huge amounts of capital almost instantly. Say, for example, a for-profit chain produces $1 million in earnings. If the company's stock is selling at a price-to-earnings ratio of 12-1, the company can issue new stock and gain $12 million in new equity capital. With that $12 million in new equity, the company can go to the debt market and borrow another $12 million. The result is that the for-profit firm can leverage initial earnings of $1 million into $25 million of capital. The nonprofit hospital, by comparison, cannot sell stock. It can use its $1 million earnings to borrow another $1 million—for $2 million of capital" (Lefton, 1985:37). The clear implication of this pronouncement is that investor-owned hospitals possess a special kind of magic in the markets for financial capital—something approximating the legendary money pump.

How valid are these impressions? Is equity capital really as cheap as the preceding example would suggest? And do investor-owned hospitals really possess a money pump, as this senior vice president's illustration implies? Students of corporation finance will answer both questions in the negative. Responsibly utilized, equity financing is typically more expensive than is debt financing. Furthermore, equity financing would be a money pump only if analysts in the financial markets were unbelievably incompetent. The major advantages of equity financing lie in its flexibility and in the additional sources of financing that it makes available, not in its cost or its supposed availability just for the asking. A detailed discussion of equity financing will be found in the Appendix to this chapter.

The Level Playing Field Argument

Arguments about policy issues regarding for-profit and not-for-profit health care organizations frequently refer to the levelness of the playing field on which such organizations compete. Generally, it is alleged that either for-profit or not-for-profit organizations have been given an unfair competitive advantage by governmental policies, and it is implied that fairness in this regard should be an important goal of health policy. Much of this debate is concerned with issues of capital financing.

Thus, critics of for-profit providers have argued that access to equity financing gives them a decided advantage over not-for-profit providers, who cannot issue common stock. As discussed earlier, it is often alleged that the ability to print and sell common-stock certificates endows for-profit providers with the ability to print money. The analysis presented in the Appendix to this chapter shows that this view of investor-equity capital as essentially costless is quite wrong. However, access to any unique and important source of capital is a significant advantage, an advantage that is enhanced by the additional borrowing power that such access makes possible. Another advantage enjoyed by the for-profit sector is the receipt of "return-on-equity" payments as a reimbursable capital cost from Medicare and some other third-party payers.

The for-profit sector also benefits from tax provisions (investment tax credits, accelerated cost recovery) that are designed to encourage investment and that allow deferral of corporate income taxes. Thus, as shown in Table 3.5, corporate taxes paid by the four largest investor-owned hospital companies in 1984 averaged 52 percent of the basic corporate tax rate, and the companies varied widely (from 29 percent to 77 percent) in this regard.

On the other hand, spokesmen for for-profit providers point out certain advantages enjoyed by not-for-profit health care providers. First is their ability to procure funds through the sale of tax-exempt bonds. Although for-profit health care organizations have in some limited circumstances procured financing through tax-exempt bonds—particularly industrial development bonds—this device is largely available to the not-for-profit sector. The monetary advantage of such financing depends on the spread between the interest rates that institutions have to pay to sell tax-exempt debt and the rate they would otherwise have to pay (an interest cost that has of late saved them 20-40 percent, depending on the length of time before the bond matures). As a tax expenditure, tax-exempt bonds represented a government subsidy of $1.065 billion for not-for-profit health care institutions in 1984 (Executive Office of the President, 1985). Of course, from the government's broader standpoint, the availability of tax-exempt financing reduced hospitals' capital expenses, 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 exemption 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 superficial appeal, it does not appear to be a sensible goal for public policy. Part of the difficulty lies in devising a practical definition of a level playing field.

First, a level playing field between for-profit and not-for-profit health care organizations would require that competitors procure 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 differences in this regard. Also, a level playing field would require, inter alia, similar incentives and burdens in the tax code. Again, the departure from this condition is virtually definitional. A level playing field would presumably require that both forms of providers sell their outputs in the same market, to identical sets of potential patients, on identical terms. But data on geographic locations 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 require that competitors be expected by society 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 clearly pursue missions that have little to do with profitability.

The conditions that would level the playing 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 becomes very complex and, inevitably, judgmental. Each form has advantages that are incommensurate with the other's advantages.

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 government is also important on its own terms. Likewise, the question of whether tax-exempt 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 fulfill or continue 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 services of acceptable quality are available to all who need them.

The major circumstance in which questions of a level playing field might gain importance is if the advantages and disadvantages conveyed on the different forms affected their ability to survive. If governmental policy were such that the existence 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 Capital

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 continued availability of tax-free bond funding. The committee's discussions of these very complex issues led to several general conclusions.

First, the committee concluded that it is essential that Medicare continue to meet its obligations of paying for the cost of procuring 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, extended care, alcohol treatment, rehabilitation 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 prospectively set DRG rates. Under a prospective payment system the committee sees no justification for differential payments (e.g., for return on equity) on the basis of for-profit or not-for-profit status.

The change in methods of paying for capital should not be the occasion, however, to starve institutions. Among other effects, such a policy would be likely to change significantly the current balance between the for-profit and not-for-profit sectors. Some evidence presented in Chapter 4 and Chapter 5 suggests that for-profit providers respond more closely to economic incentives, implying that their response to such circumstances might be to reduce services more quickly, to introduce more differential pricing (particularly in multi-institutional systems 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 mission (such as reducing indigent care) by spending reserves that are needed to fund future capital improvements, thereby significantly weakening themselves in an increasingly competitive environment. The alternative of institutions' abandoning traditional missions would be equally unfortunate.

If in view of the widespread excess capacity in the hospital sector the government decides to constrain the flow of funds that allow capital formation in this sector, mechanisms should be created for establishing exceptions in situations of merit (e.g., tertiary care institutions with high costs for technology and specialized personnel, vital training centers committed to health professional education, institutions with a high indigent 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 making capital available to many institutions that otherwise would have no chance to obtain it (Cohodes and Kinkead, 1984). Furthermore, some institutions in the 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 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. The committee strongly believes in the importance of a not-for-profit sector in health care, and that it is imperative that tax-exempt financing 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 approval 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. Because 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 considered.

References

• American Association of Fund Raising Counsel, Inc. (AAFRC) (1985) Giving USA: A Compilation of Facts 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 Solutions—1984. Chicago, Ill.: American Hospital Association.

• 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-Profit and Investor-Owned Hospitals. Chicago, Ill.: American Hospital Association.

• Charhut, Maureen M. (1984) Trends in Hospital Philanthropy. Hospitals 58(March 16):70-74. [PubMed: 6698519]

• Cohen, Harold A., and Jack C. Keane (1984) Approaches to Setting the Level of Payment. Hospital Capital Finance Background Paper prepared for Assistant 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. Health Services Research 19(April):41-63. [PMC free article: PMC1068788] [PubMed: 6724955]

• Executive Office of the President, Office of Management and Budget (1985) Budget of the United States Government, FY 1986. Special Analysis G, Tax-Expenditures, Table G-2 (Revenue Loss Estimates for Tax Expenditures by Functions), p. G-46.

• 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) Annual Report. Boston, Mass.

• Hernandez, Michael D., and Arthur J. Henkel (1982) Need for Capital May Squeeze Freestanding Institutions into Multi-institutional Arrangements. Hospitals 56(March 1):75-77. [PubMed: 7056537]

• Hospital Financial Management Association (1980) Hospital Financial Management Association Principles and Practices Board, Statement 3. Hospital Financial Management 34:50-59. [PubMed: 10252791]

• Humana, Inc. (1984) Annual Report. Louisville, Ky.

• ICF Incorporated (1983) Assessment of Recent Estimates of Hospital Capital Requirements. Contract study done for Assistant Secretary for Planning and Evaluation, DHHS. Washington, D.C.: ICF Incorporated.

• Kinkead, Brian (1984) Historical Trends in Hospital Capital Investment. Report prepared for the Assistant Secretary for Planning and Evaluation, DHHS. Washington, D.C.: Department of Health and Human Services.

• 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 Not-for-Profit 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.

• 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 Brookings Institution, 1967.

• Watt, J. Michael, Steven C. Renn, James S. Hahn, Robert A. Derzon, and Carl J. Schramm (1986) The Effects of Ownership and Multihospital System Membership on Hospital Functional Strategies and Economic Performance. 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):1426-1430. [PubMed: 7133097]

Appendix To Chapter 3. The Nature Of Equity Financing

Uwe Reinhardt

Equity financing is a topic about which misconceptions exist, such as the belief that equity capital is a cheap and plentiful source of funds. Although access to equity capital has significant advantages, these advantages are less than often supposed. These points become clear if the topic is examined carefully.

To understand the nature of equity financing, 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 shareholders. From that perspective the owners then become just another source of financial capital. They are individuals or institutions willing to supply the firm with funds against what one might call a veritable "hope-and-prayer" paper, 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 of the 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. Furthermore, 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 demonstrates, 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 funds entrusted to them. They transmit this pressure explicitly to the corporations whose stock they hold, and they have shown no hesitation to throw managements that have disappointed them to the mercies of corporate raiders.

In soliciting funds from potential investors against newly issued common-stock certificates, the firm's management must convince these investors that their investment will ultimately 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 funds and the risk premium—is referred to in the literature 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 the certificates an annual cash dividend of $6 per share for the indefinite future. For the moment it is convenient to assume that this dividend exhausts the firm's net after-tax income, that is, that the firm does not retain any income at all. 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 annual 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 an annual return of $6 is exactly 15 percent of $40. The price of $40 per share can also be referred to as the present, discounted value of the future dividend stream, which is calculated as the sum

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 payment of an annual cash dividend of $6 per share to shareholders. Although modern accounting rules would define the $6 as part of corporate "profits," from this firm's perspective that dividend actually can be viewed as a cost of procuring the equity funds that sustain the corporation's activities. The annual dividend is a cost of financing in this sense. It is the analogue of interest on debt. In our example this cost of equity financing can be expressed 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 financing 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 financing, 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 after-tax basis it would be only about one-third as high (precisely the opposite of the erroneous conclusion reached 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 of the new stock issue an apologetic management of the ABC Corporation 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 investments of this kind would then pay only $30 per share of the company's stock. Investors who originally bought the 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 original investment of $40 per share.

It may be interjected at this point that the relative cheapness of equity, financing lies precisely 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 premium may well have been 15 percent, it may be argued, the firm's cost of equity financing ex post was only 11.25 percent. In fact, if management had wished to do so, it could have reduced ABC Corporation's cost of equity financing 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 present example, the firm obviously could sell additional shares of stock only at $30 per share, and perhaps not even at that much lower a price. Having been disappointed once, investors 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 income 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 dividend 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 would keep the shareholders whole—that is, it would maintain the market price per share—if the earnings retained in the firm were invested in assets yielding an annual return of at least 15 percent. In other words, responsibly 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 opportunity 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 elsewhere. Although the taxation of dividends and the cost of issuing new stock certificates complicates 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 to the cost of equity financing procured by the sale of new stock certificates.

All of the preceding illustrations have assumed fiat annual dividends of either $6 or $4.50 in perpetuity. In reality, such a projection would be rare. More typically, corporations project and potential investors assume that dividends per share will grow over time. ABC Corporation had led investors to expect not a fiat 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 expression

As before, the firm's after-tax cost of equity capital would be 15 percent. By itself the change in the time path of future cash dividends would not alter the firm's cost of equity capital (unless, of course, the change affected the risk 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 projected dividend stream can be used to illustrate the role of growth in the valuation of common stock. Let P denote the current market 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 required rate of return (r). Then one could solve this expression for the expected growth rate (g) implicit in these numbers as follows:

It has been shown in Chapter 3 that in 1984 Humana, Inc., paid its shareholders a dividend 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-D/P) 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 approximation of the algorithm actually used by investors to value Humana stock, the general proposition implicit in the illustration is nevertheless 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 investor-owned hospital chain must pursue a high-growth policy to survive in the financial markets. 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 itself to a high-growth strategy. This conclusion 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 preceding conclusions were forced by the highly unrealistic 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 horizon 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 P 1 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 dividend, and r the rate of return the investor wishes to earn on this investment, then the current market price (P 0) that investor would be willing to pay per share of the stock would be

How would investors formulate their expectation of the future resale price P 1? Presumably, they would put themselves into the shoes of investors who would contemplate purchasing the stock one year hence. The latter could be expected to follow the same algorithm currently being followed by investors, with all of the variables pushed one year further into the future. By simple extension, an entire succession of such investors would eventually convert 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 future dividend stream.

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 (P 0) we can obtain the following expression for the investor's expected annual rate of return:

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 substitutes 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 current 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 additional 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 million of additional financing would consist of $12 million additional debt, $12 million procured by issuing additional common-stock certificates, and $1 million of retained earnings, the assumption being that not a penny of the $1 million in earnings would be paid out in dividends. Presumably, the suppliers of these funds would expect the usual "rentals" in return for parting 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 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 expense. 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.1

In addition to the extra net income that would be required to service the $12 million of additional debt, additional future earnings would be required to compensate the suppliers of the additional $13 million in equity financing. If we assume that the hospital chain's shareholders 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 provide that level of return through dividends would require pretax earnings of $3.61 million, if the chain's profit tax rate were 46 percent. (If it were intended to provide the return mainly through capital gains, then future dividends 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 revenue) 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 additional $30 million or more in extra annual revenues would have to be yielded by the additional $25 million of assets that were financed 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 financed 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 million or so, then that not-for-profit chain, too, 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 succumbed 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:

From the perspective of the firm as an entity, equity financing is just another source of financing requiring the firm to earn sufficient revenues to reward the suppliers of such funds for parting with their money.

The reward the firm must offer the suppliers of equity funds must be sufficiently high to compensate the suppliers for the opportunity, cost of parting with their funds and for the risk they assume by accepting the relative uncertain stream of rewards implicit in common-stock certificates. This minimally required level of reward is the firm's cost of equity capital.

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 normal debt-to-equity ratios.

From the firm's perspective, the major advantage of equity financing lies in the flexibility, it offers management to phase the reward stream paid to shareholders over time. Under a debt contract the reward stream is rigidly fixed and legally enforceable. Under the common-stock contract the firm (with the approval of its board of directors) can trade off reward payments at one time for higher reward payments later on.

In an environment dominated by institutional investors in the role of shareholders, a firm's management cannot breach with impunity the promises made explicitly or implicitly to shareholders.

In conducting their affairs many investor-owned hospital chains appear to have chosen low current dividend yields in exchange for an implicit promise of rapid growth in future earnings per share and dividends. Companies could, for example, pay dividends that approximate prevailing interest rates. This growth imperative is a deliberate managerial choice, but not, in principle, a necessary condition for survival in the for-profit hospital market.

The much vaunted ability of investor-owned chains to parlay current earnings into high multiples of additional financing is an exaggeration based on a misperception of the financial community.

There is the added insight that the "profits" reported by investor-owned business firms 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 average pretax interest rate of 12 percent per year, and that the rest of the financing has come from shareholders through original contributions of funds or through retained earnings. If that 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

TABLE 3-A.1

Income Statement for a Hypothetical Business Corporation, Fiscal Year 19xx (millions of dollars).

From the firm's net operating income of $250 million, there would be deducted, first, its annual coupon interest of $48 million. The remainder would be the firm's taxable income. If the firm did not avail itself of any tax loopholes or deferrals, and if it faced a profit tax rate of 46 percent, its after-tax net income would be $109 million. This amount would be available for distribution to shareholders or retention in the firm on behalf of shareholders. Under modern accounting practices the entire $109 million would be reported as the firm's "profits."

In textbooks and writings, economists differ sharply with accountants on this point. As is shown in Table 3-A.1, economists would define "profits" as the residual after deduction of the cost of equity capital from reported book profits. If it is assumed, as before, that shareholders minimally require a rate of return of 15 percent per year on funds entrusted to the firm under the common-stock contract, then the economists measure of "profits" 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—S90 million in the present example—is treated simply as part of the firm's cost of doing business.

1. 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 Planning 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), The National Committee for Quality Health Care's "Proposed Method for Incorporating Capital-Related Costs Within the Medicare Prospective Payment System" (1084), 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.

2. The term "financial capital" stands in distinction to "physical capital"—which refers to facilities, equipment, 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.

3. Laypersons not familiar with either accounting or corporation finance frequently think only of equipment, structures, and land when they speak of "capital." 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.

4. Arguments have been made in recent years that not-for-profit institutions have the same need for return-on-equity payments as do for-profit institutions and that Medicare's movement to a prospective pricing system removes any justification for differences in payments 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).

5. The 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 provided 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 36-38 percent of payments to investor-owned hospitals.

6. To 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 shareholders 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. Furthermore, 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 figures.

Under the accelerated cost recovery system (ACRS) legislated in 1981, however, the firm actually would be able to depreciate the asset over only three years for purposes of calculating taxable income to be reported to the Internal Revenue Service (IRS). The annual 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 shareholders would exceed the taxes it actually paid. This divergence gives rise to the so-called "deferred income taxes due" shown as a liability on the firm's balance sheet. Accountants treat this expense as a liability because 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 expense 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.

7. For example, a recent survey by the National Association for Hospital Development of its members (individuals with fund-raising responsibilities in hospitals) found that the hospitals surveyed had budgeted 0.9 percent of their overall budgets for development purposes and that they were planning to devote 1.4 percent of their budgets to this purpose in 1985 (AAFRC, 1985).

8. These constraints typically include appointing a trustee (usually a bank) to monitor economic performance and to take appropriate actions on behalf of the bondholders, including taking possession of the hospital on behalf of the bondholders in the event of default; 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 operating the institution to meet various indicators of financial performance and status (e.g., debt-to-equity ratios).

9. Data published by the American Hospital Association (1984) show the 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 $3,89,5,787 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 exemption from federal income taxes was very valuable to the not-for-profit hospital sector.

1. At the conceptual level, one can visualize the required 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 firm would annually deduct an allowed depreciation expense based on the value of the underlying assets. The annual depreciation 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 revenues 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 depreciation expense in a fund designated for the repayment 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 expense.

Portions of this chapter are based on material prepared by committee member Uwe Reinhardt, Ph.D., who also prepared the analysis of the cost of equity capital that is appended to this chapter.