. 12
( 21)







0 0.5 1.0 1.5 2.0 Risk (b)
316 Healthcare Finance

the basis of current information. The SML, its use, and how its input values
are estimated, are covered in greater detail in Chapter 13.

Advantages and Disadvantages of the CAPM
A word of caution about beta coef¬cients and the CAPM is in order. To begin,
the CAPM is based on a very restrictive set of assumptions that does not con-
form well to real-world conditions. Second, although the concepts are logical,
the entire theory is based on expectations, while only historical data are avail-
able. Thus, the market betas that are calculated and reported in practice show
how volatile a stock has been in the past. However, conditions may change,
and a stock™s future volatility”the item of real concern to investors”might
be quite different from its past volatility. Although the CAPM represents a
very important contribution to risk and return theory, it does have potentially
serious problems when applied in practice.
In spite of these concerns, the CAPM is extremely appealing because
it is simple and logical. It focuses on the impact that a single investment has
on a portfolio, which in most situations is the correct way to think about risk.
Furthermore, it tells us that the required rate of return on an investment is
composed of the risk-free rate, which compensates investors for time value,
plus a risk premium that is a function of investors™ attitudes toward risk
bearing in the aggregate and the speci¬c portfolio risk of the investment being
evaluated. Because of these points, the CAPM is an important conceptual tool.
However, its actual use to set required rates of return must be viewed with
some caution. We will have more to say about the use of the CAPM in practice
in Chapter 13.

Self-Test 1. What is the Capital Asset Pricing Model (CAPM)?
Questions 2. What is the appropriate measure of risk in the CAPM?
3. Write out the equation for the Security Market Line (SML), and then
graph it.
4. Describe the SML in words.
5. What are the advantages and disadvantages of the CAPM?

Key Concepts
This chapter has covered the very important topics of ¬nancial risk and
required return. The key concepts of this chapter are:
• Risk de¬nition and measurement is very important in ¬nancial
management because decision makers, in general, are risk averse and hence
require higher returns from investments that have higher risk.
• Financial risk is associated with the prospect of returns less than
anticipated. The higher the probability of a return being far less than
anticipated, the greater the risk.
Chapter 10: Financial Risk and Required Return

• The riskiness of investments held in isolation, called stand-alone risk, can
be measured by the dispersion of the rate of return distribution about its
expected value. One commonly used measure of stand-alone risk is the
standard deviation of the return distribution.
• Most investments are not held in isolation but as part of a portfolio.
Individual investors hold portfolios of securities, and businesses hold
portfolios of projects (i.e., products and services).
• When investments with returns that are less than perfectly positively
correlated are combined in a portfolio, risk is reduced. The risk reduction
occurs because less-than-expected returns on some investments are offset
by greater-than-expected returns on other investments. However, among
real-world investments, it is impossible to eliminate all risk because the
returns on all assets are in¬‚uenced to a greater or lesser degree by overall
economic conditions.
• That portion of the stand-alone risk of an investment that can be
eliminated by holding the investment in a portfolio is called diversi¬able
risk, while the risk that remains is called portfolio risk.
• There are two different types of portfolio risk. Corporate risk is the
riskiness of business projects when they are considered as part of a
business™s portfolio of projects. Market risk is the riskiness of business
projects (or of the stocks of entire businesses) when they are considered as
part of an individual investor™s well-diversi¬ed portfolio of securities.
• Corporate risk is measured by a project™s corporate beta, which re¬‚ects the
volatility of the project™s returns relative to the volatility of returns of the
aggregate business.
• Market risk is measured by a project™s or stock™s market beta, which
re¬‚ects the volatility of a project™s (or stock™s) returns relative to the
volatility of returns on a well-diversi¬ed stock portfolio.
• Stand-alone risk is most relevant to investments held in isolation; corporate
risk is most relevant to projects held by not-for-pro¬t ¬rms and by small
owner-managed for-pro¬t businesses; and market risk is most relevant to
projects held by large investor-owned corporations.
• The overall beta coef¬cient of a portfolio is the weighted average of the
betas of the components of the portfolio, where the weights are the
proportion of the overall investment in each component. Therefore, the
weighted average of corporate betas of all projects in a business must equal
1.0, while the weighted average of all projects™ market betas must equal
the market beta of the ¬rm™s stock.
• The Capital Asset Pricing Model (CAPM) is an equilibrium model that
describes the relationship between market risk and required rates of return.
• The Security Market Line (SML) provides the actual risk/required rate of
return relationship. The required rate of return on any stock is equal to
the risk-free rate plus the market risk premium times the stock™s market
beta coef¬cient: R(Re) = RF + [R(RM) ’ RF)] — b = RF + (RPM — b).
318 Healthcare Finance

This concludes the discussion of basic ¬nancial management concepts. The
next chapter begins our coverage of long-term ¬nancing.

10.1 When considering stand-alone risk, the return distribution of a less
risky investment is more peaked (“tighter”) than that of a riskier
investment. What shape would the return distribution have for an
investment with (a) completely certain returns and (b) completely
uncertain returns.
10.2 Stock A has an expected rate of return of 8 percent, a standard
deviation of 20 percent, and a market beta of 0.5. Stock B has an
expected rate of return of 12 percent, a standard deviation of 15
percent, and a market beta of 1.5. Which investment is the riskier?
Why? (Hint: Remember that the risk of an investment depends on its
10.3 a. What is risk aversion?
b. Why is risk aversion so important to ¬nancial decision making?
10.4 Explain why holding investments in portfolios has such a profound
impact on the concept of ¬nancial risk.
10.5 Assume that two investments are combined in a portfolio.
a. In words, what is the expected rate of return on the portfolio?
b. What condition must be present for the portfolio to have lower
risk than the weighted average of the two investments?
c. Is it possible for the portfolio to have lower risk than that of either
d. Is it possible for the portfolio to be riskless? If so, what condition
is necessary to create such a portfolio?
10.6 Explain the difference between portfolio risk and diversi¬able risk.
10.7 What are the implications of portfolio theory for investors?
10.8 a. What are the two types of portfolio risk?
b. How is each type de¬ned?
c. How is each type measured?
10.9 Under what circumstances is each type of risk”stand alone, corporate,
and market”most relevant?
10.10 a. What is the Capital Asset Pricing Model (CAPM)? The security
market line (SML)?
b. What are the weaknesses of the CAPM?
c. What is the value of the CAPM?

10.1 Consider the following probability distribution of returns estimated for
a proposed project that involves a new ultrasound machine:
Chapter 10: Financial Risk and Required Return

State of Probability of
the Economy Occurrence Rate of Return
Very poor 0.10
Poor 0.20 0.0
Average 0.40 10.0
Good 0.20 20.0
Very good 0.10 30.0

a. What is the expected rate of return on the project?
b. What is the project™s standard deviation of returns?
c. What is the project™s coef¬cient of variation (CV) of returns?
d. What type of risk does the standard deviation and CV measure?
e. In what situation is this risk relevant?
10.2 Suppose that a person won the Florida lottery and was offered a choice
of two prizes: (1) $500,000 or (2) a coin-toss gamble in which he or
she would get $1 million if a head were ¬‚ipped and zero for a tail.
a. What is the expected dollar return on the gamble?
b. Would the person choose the sure $500,000 or the gamble?
c. If he or she chooses the sure $500,000, is the person a risk averter
or a risk seeker?
10.3 Refer to Table 10.2.
a. Construct an equal-weighted (50/50) portfolio of Investments B
and C. What is the expected rate of return and standard deviation of
the portfolio. Explain your results.
b. Construct an equal-weighted (50/50) portfolio of Investments B
and D. What is the expected rate of return and standard deviation
of the portfolio. Explain your results.
10.4 Suppose that the risk-free rate, RF, were 8 percent and the required
rate of return on the market, R(RM), were 14 percent.
a. Write out the Security Market Line (SML), and explain each term.
b. Plot the SML on a sheet of paper.
c. Suppose that in¬‚ation expectations increase such that the risk-free
rate, RF, increases to 10 percent and the required rate of return on
the market, R(RM), increases to 16 percent. Write out and plot the
new SML.
d. Return to the original assumptions in this problem. Now, suppose
that investors™ risk aversion increases and the required rate of return
on the market, R(RM), increases to 16 percent. (There is no change
in the risk-free rate because RF re¬‚ects the required rate of return
on a riskless investment.) Write out and plot the new SML.
10.5 A few years ago, the Value Line Investment Survey reported the
following market betas for the stocks of selected healthcare providers:
320 Healthcare Finance

Company Beta
Quorum Health Group 0.90
Beverly Enterprises 1.20
HEALTHSOUTH Corporation 1.45
United Healthcare 1.70

At the time these betas were developed, reasonable estimates for the
risk-free rate, RF, and required rate of return on the market, R(RM),
were 6.5 percent and 13.5 percent, respectively.
a. What are the required rates of return on the four stocks?
b. Why do their required rates of return differ?
c. Suppose that a person is planning to invest in only one stock rather
than hold a well-diversi¬ed stock portfolio. Are the required rates of
return calculated above applicable to the investment? Explain your
10.6 Suppose that Apex Health Services has four different projects. These
projects are listed below, along with the amount of capital invested and
estimated corporate and market betas:

Amount Corporate Market
Project Invested Beta Beta
Walk-in clinic $ 500,000 1.5 1.1
MRI facility 2,000,000 1.2 1.5
Clinical laboratory 1,500,000 0.9 0.8
X-ray laboratory 1,000,000 0.5 1.0

a. Why do the corporate and market betas differ for the same project?
b. What is the overall corporate beta of Apex Health Services? Is the
calculated beta consistent with corporate risk theory?
c. What is the overall market beta of Apex Health Services?
d. How does the riskiness of Apex™s stock compare with the riskiness
of an average stock?
e. Would stock investors require a rate of return on Apex that is greater
than, less than, or the same as the return on an average-risk stock?
10.7 Assume that HCA is evaluating the feasibility of building a new hospital
in an area not currently served by the company. The company™s
analysts estimate a market beta for the hospital project of 1.1, which is
somewhat higher than the 0.8 market beta of the company™s average
project. Financial forecasts for the new hospital indicate an expected
rate of return on the equity portion of the investment of 20 percent.
If the risk-free rate, RF, is 7 percent and the required rate of return
on the market, R(RM), is 12 percent, is the new hospital in the best
interest of HCA™s shareholders? Explain your answer.
Chapter 10: Financial Risk and Required Return

1. De¬ning ¬nancial risk as the probability of earning a return far below that
expected is somewhat simplistic. As we discussed previously, there are many
different ways of viewing ¬nancial risk. However, the simple de¬nition presented
here is a good starting point for discussing the types of risk that are most relevant
to decisions made within health services organizations.
2. Most ¬nancial calculators and spreadsheet programs have built-in functions
that calculate standard deviation. However, these functions assume that the
distribution values entered have equal probabilities of occurrence and hence
are not usable with the types of distributions contained in Table 10.1. Such
functions are designed to handle historical data, such as annual returns over the
past ¬ve years, as opposed to forecasted distributions with unequal probabilities
of occurrence.
3. Consider what the slope of the line would be if the portfolio™s returns were
plotted on both the X and Y axes. The regression line would be a 45-degree line,
which has a slope of 1.0. Thus, an average risk investment, as de¬ned by the risk
of the portfolio, has a slope of 1.0. In fact, Investment M has the same return
distribution as Portfolio P, so the M regression line is identical to that for P.
4. In these illustrations, the same probability distributions are being used to
illustrate both corporate risk and market risk. In reality, it is unlikely that returns
on a particular ¬rm and returns on the market portfolio would be the same. (The
portfolio returns in the right column of Table 10.3 would not be identical for
both a given ¬rm and for the market portfolio.) This reality would cause the lines
plotted in Figure 10.2 to have different slopes and hence different corporate and
market betas”for example, Project H may have a corporate beta of 1.5 and a
market beta of 1.2. In general, a project™s corporate beta and market beta will

Brigham, E. F., and M. C. Ehrhardt. 2002. Financial Management: Theory and Prac-
tice (Chapters 6 and 7). Fort Worth, TX: Harcourt College Publishers.
Gapenski, L. C. 1992. “Project Risk De¬nition and Measurement in a Not-for-Pro¬t
Setting.” Health Services Management Research (November): 216“24.
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Long-Term Financing
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Learning Objectives
After studying this chapter, readers will be able to:

• Describe how interest rates are set in the economy.
• Discuss the various types of long-term debt instruments and their
• Discuss the components that make up the interest rate on a debt
• Value debt securities.

If a business is to operate, it must have assets. To acquire assets, it must raise
capital. Capital comes in two basic forms: debt and equity. Historically, capital
furnished by the owners of investor-owned businesses (i.e., stockholders of
for-pro¬t corporations) was called equity capital, while capital obtained by
not-for-pro¬t businesses from grants, contributions, and retained earnings was
called fund capital. Both types of capital serve the same purpose in ¬nancing
businesses”providing a permanent ¬nancing base without a contractually
¬xed cost”so today the term equity is often used to represent nonliability
capital regardless of ownership type.
In addition to equity ¬nancing, most healthcare businesses use a con-
siderable amount of debt ¬nancing, which is provided by creditors. For ex-
ample, Value Line reports that, on average, healthcare providers ¬nance their
assets with 5 percent short-term debt, 30 percent long-term debt, and 65
percent equity as measured by balance sheet amounts. Thus, over one-third
of providers™ ¬nancing comes from debt. In this chapter, many facets of debt
¬nancing are discussed, including important background material related to
how interest rates are set in the economy. The discussion here focuses on
long-term debt; short-term debt is discussed in Chapter 16.

The Cost of Money
Capital in a free economy is allocated through the price system. The interest
rate is the price paid to obtain debt capital, whereas in the case of equity
capital in for-pro¬t ¬rms, investors™ returns come in the form of dividends
326 Healthcare Finance

and capital gains or losses. The four most fundamental factors that affect the
supply of and demand for investment capital, and hence the cost of money,
are investment opportunities, time preferences for consumption, risk, and
in¬‚ation. To see how these factors operate, visualize the situation facing Lori
Gibbs, an entrepreneur who is planning to found a new home health agency.
Lori does not have suf¬cient personal funds to start the business, so she must
supplement her equity capital with debt ¬nancing.

Investment Opportunities
If Lori estimates that the business will be highly pro¬table, she will be able
to pay creditors a higher interest rate than if it is barely pro¬table. Thus,
her ability to pay for borrowed capital depends on the business™s investment
opportunities. The higher the pro¬tability of the business, the higher the
interest rate that Lori can afford to pay lenders for use of their savings.

Time Preferences for Consumption
The interest rate lenders will charge depends in large part on their time
preferences for consumption. For example, one potential lender, Jane Wright,
may be saving for retirement, so she may be willing to loan funds at a relatively
low rate because her preference is for future consumption. Another person,
John Davis, may have a wife and several young children to clothe and feed,
so he may be willing to lend funds out of current income, and hence forgo
consumption, only if the interest rate is very high. John is said to have a high
time preference for consumption and Jane a low time preference. If the entire
population of an economy were living right at the subsistence level, time
preferences for current consumption would necessarily be high, aggregate
savings would be low, interest rates would be high, and capital formation
would be dif¬cult.

The risk inherent in the prospective home health care business, and thus in
Lori™s ability to repay the loan, would also affect the return lenders would
require: the higher the risk, the higher the interest rate. Investors would be
unwilling to lend to high-risk businesses unless the interest rate was higher
than on loans to low-risk businesses.

Finally, because the value of money in the future is affected by in¬‚ation, the
higher the expected rate of in¬‚ation, the higher the interest rate demanded
by savers. Debt suppliers must demand higher interest rates when in¬‚ation is
high to offset the resulting loss of purchasing power.

Note that to simplify matters, the illustration implied that savers would
lend directly to businesses that need capital, but in most cases the funds would
C h a p t e r 1 1 : Lo n g - Te r m D e b t F i n a n c i n g

actually pass through a ¬nancial intermediary such as a bank or a mutual fund.
Also, note that we used the interest rate on debt capital to illustrate the four
factors, but the same logic applies to the cost of all investment capital.

1. What is the “price” of debt capital?
2. What four factors affect the cost of money?

Common Long-Term Debt Instruments
There are many different types of long-term debt. Some types, such as home
mortgages and auto loans, are used by individuals, while other types are
use primarily by businesses. In this section, we discuss the long-term debt
instruments most commonly used by healthcare businesses.

Term Loans
A term loan is a contract under which a borrower agrees to make a series
of interest and principal payments, on speci¬ed dates, to a lender. Investment
bankers are generally not involved; term loans are negotiated directly between
the borrowing business and the lender. Typically, the lender is a ¬nancial
institution such as a commercial bank, a mutual fund, an insurance company,
or a pension fund, but it can also be a wealthy private investor. Most term
loans have maturities of three to 15 years.
Like home mortgages, term loans are usually amortized in equal install-
ments over the life of the loan, so part of the principal of the loan is retired with
each payment. For example, Sacramento Cardiology Group has a $100,000
¬ve-year term loan with Bank of America to fund the purchase of new diag-
nostic equipment. The interest rate on the ¬xed-rate loan is 10 percent, which
obligates the Group to ¬ve end-of-year payments of $26,379.75. Thus, loan
payments total $131,898.75, of which $31,898.75 is interest and $100,000
is repayment of principal (i.e., the amount borrowed).
Term loans have three major advantages over bonds (the other major
category of long-term debt, which we discuss in the next section): speed,
¬‚exibility, and low administrative costs. Because term loans are negotiated
directly between an institutional lender and the borrower, as opposed to
being sold to the general public, formal documentation is minimized. The key
provisions of the loan can be worked out much more quickly, and with more
¬‚exibility, than can those for a public issue. Furthermore, it is not necessary for
a term loan to go through the Securities and Exchange Commission (SEC)
registration process. Finally, after a term loan has been negotiated, changes
can be renegotiated more easily than with bonds if ¬nancial circumstances so
The interest rate on a term loan either can be ¬xed for the life of the
loan or variable. If it is ¬xed, the rate used will be close to the rate on equivalent
328 Healthcare Finance

maturity bonds issued by businesses of comparable risk. If the rate is variable,
it is usually set at a certain number of percentage points over an index rate
such as the prime rate.1 When the index rate goes up or down, so does the
interest rate that must be paid on the outstanding balance of the term loan.

Like a term loan, a bond is a long-term contract under which a borrower agrees
to make payments of interest and principal, on speci¬c dates, to the holder of
the bond. Although bonds are similar in many ways to term loans, a bond
issue generally is registered with the SEC, advertised, offered to the public
through investment bankers, and actually sold to many different investors.
Indeed, thousands of individual and institutional investors may participate
when a ¬rm, such as HCA, sells a bond issue, while there is generally only
one lender in the case of a term loan.
Bonds are categorized as either government (Treasury), corporate, or
municipal. Government, or Treasury, bonds are issued by the U.S. Treasury
and are used to raise money for the federal government.2 Because Treasury
bonds are not used by businesses, we will not discuss them here.

Corporate Bonds
Corporate bonds are issued by investor-owned ¬rms, while municipal bonds are
issued by governments and governmental agencies other than federal. In this
section, the primary focus is on corporate bonds, but much of the discussion
also is relevant to municipal bonds. The unique features of municipal bonds
will be discussed in the next major section.
Although corporate bonds generally have maturities in the range of 20
to 30 years, shorter maturities, as well as longer maturities, are occasionally
used. In fact, in 1995, HCA (then Columbia/HCA) issued $200 million
of 100-year bonds, following the issuance of 100-year bonds by Disney and
Coca-Cola in 1993. These ultra-long term bonds had not been used by any
¬rm since the 1920s. Unlike term loans, bonds usually pay only interest over
the life of the bond, with the entire amount of principal returned to lenders
at maturity.
Most bonds have ¬xed interest rates, which locks in the current rate
for the entire maturity of the bond and hence minimizes interest payment
uncertainty. However, some bonds have ¬‚oating, or variable, rates that are
tied to some interest rate index, so the interest payments move up and down
with the general level of interest rates.

Mortgage With a mortgage bond, the issuer pledges certain real assets as security for the
Bonds bond. To illustrate the concept, consider the following example. Mid-Texas
Healthcare System recently needed $100 million to purchase land and to build
a new hospital. First mortgage bonds in the amount of $30 million, secured
by a mortgage on the property, were issued. If the ¬rm defaults (fails to make
C h a p t e r 1 1 : Lo n g - Te r m D e b t F i n a n c i n g

the promised payments) on the bonds, the bondholders could foreclose on
the hospital and sell it to satisfy their claims.
Mid-Texas could, if it so chose, also issue second mortgage bonds secured
by the same $100 million hospital. In the event of bankruptcy and liquidation,
the holders of these second mortgage bonds would have a claim against the
property only after the ¬rst mortgage bondholders had been paid off in full.
Thus, second mortgages are sometimes called junior mortgages, or junior
liens, because they are junior in priority to claims of senior mortgages, or
¬rst mortgage bonds.

A debenture is an unsecured bond, and as such, it has no lien against speci¬c Debentures
property as security for the obligation. For example, Mid-Texas Healthcare
System has $5 million of debentures outstanding. These bonds are not secured
by real property but are backed instead by the revenue-producing power of the
corporation. Debenture holders are, therefore, general creditors whose claims,
in the event of bankruptcy, are protected by property not otherwise pledged.
In practice, the use of debentures depends on the nature of the ¬rm™s assets
and general credit strength. If a ¬rm™s credit position is exceptionally strong, it
can issue debentures because it simply does not need to pledge speci¬c assets as
security. Debentures are also issued by ¬rms with only a small amount of assets
suitable as collateral. Finally, ¬rms that have used up their capacity to borrow in
the lower-cost mortgage market may be forced to use higher-cost debentures.

The term subordinate means “below” or “inferior.” Thus, subordinated debt Subordinated
has a claim on assets in the event of bankruptcy only after senior debt has Debentures
been paid off. Debentures may be subordinated either to designated debt”
usually bank loans”or to all other debt. In the event of liquidation, holders
of subordinated debentures cannot be paid until senior debt, as named in the
debenture, has been paid. Subordinated debentures are normally quite risky
and hence carry interest rates that are much higher than the rate on mortgage

Municipal Bonds
Municipal, or muni, bonds are long-term debt obligations issued by states and
their political subdivisions such as counties, cities, port authorities, toll road
or bridge authorities, and so on. Short-term municipal securities are used
primarily to meet temporary cash needs, while municipal bonds are usually
used to ¬nance capital projects.
There are several types of municipal bonds. For example, general obli-
gation bonds are secured by the full faith and credit of the issuing municipality
(i.e., they are backed by the full taxing authority of the issuer). Conversely,
special tax bonds are secured by a speci¬ed tax such as a tax on utility services.
Revenue bonds are bonds that are not backed by taxing power but by the
revenues derived from such projects as roads or bridges, airports, and water
330 Healthcare Finance

and sewage systems. Revenue bonds are of particular interest to not-for-pro¬t
healthcare providers because they are legally entitled to issue such securities
through government-sponsored healthcare ¬nancing authorities.
Not-for-pro¬t healthcare ¬rms issue large amounts of municipal debt.
To illustrate, such providers issued over $20 billion of municipal bonds in
2003. Recently, about 20 percent of the dollar volume of healthcare muni
bonds has had ¬‚oating rates, while the remaining 80 percent has had ¬xed
rates. Floating rate bonds are riskier to the issuer because interest rates could
rise in the future. Conversely, ¬‚oating rate bonds are less risky to buyers
because rising rates will trigger an increase in the amount of each interest
payment. However, virtually all such municipal debt has call provisions that
permit issuers to replace the ¬‚oating rate debt with ¬xed rate debt should
interest rates rise substantially. The ability to redeem the debt should interest
rates soar places a cap on the riskiness to the borrower as well as on the
potential gains to ¬‚oating rate bondholders. (Call provisions are discussed
in more detail in the next major section.)
Most municipal bonds are sold in serial form”that is, a portion of
the issue comes due periodically, anywhere from six months after issue to 30
years or more. Thus, a single issue actually consists of a series of sub-issues of
different maturities. In effect, the bond issue is amortized, with a portion of
the issue retired every year. The purpose of structuring a bond issue in this
way is to match the overall maturity of the issue to the maturity of the assets
being ¬nanced. For example, a new hospital that has a predicted useful life
of about 30 years might be ¬nanced with a 30-year serial issue. Over time,
some of the revenues associated with the new hospital will be used to meet
the debt service requirements (i.e., the interest and principal payments). At the
end of 30 years, the entire issue will be paid off, and the issuer can plan for
a replacement facility or major renovation that would be funded, at least in
part, by another debt issue.
Whereas the vast majority of federal government and corporate bonds
are held by institutions, close to half of all municipal bonds outstanding are
held by individual investors. The primary attraction of most municipal bonds is
their exemption from federal and state (in the state of issue) taxes. To illustrate,
the interest rate on an AAA-rated, long-term corporate bond recently was
5.5 percent, while the rate on a similar risk healthcare muni was 4.6 percent.
To an individual investor in the 40 percent federal-plus-state tax bracket, the
corporate bond™s after-tax yield was 5.5% — (1 ’ 0.40) = 5.5% — 0.6 =
3.3%, while the muni™s after-tax yield was the same as its before-tax yield,
4.6 percent. This yield differential on otherwise similar securities illustrates
why investors in high tax brackets are so enthusiastic about municipal bonds.

Private Versus Public Placement
Most bonds, including Treasury, corporate, and municipal, are sold through
investment bankers to the public at large. For example, the New York State
C h a p t e r 1 1 : Lo n g - Te r m D e b t F i n a n c i n g

Medical Care Facilities Financing Agency recently sold a $675 million muni-
cipal mortgage revenue issue for New York Hospital. The issue was marketed
both to the public at large and to institutional investors by Goldman Sachs &
Co., one of the top underwriters of tax-exempt healthcare issues. However,
smaller bond issues, typically $10 million or less, often are sold directly to a
single buyer or a small group of buyers. Issues placed directly with lenders,
or private placements, have the same advantages as term loans, which were
discussed in a previous section.
Although the interest rate on private placements is generally higher
than the interest rate set on public issues, the administrative costs of placing
an issue, such as legal, accounting, printing, and selling fees, are less for
private placements than for public issues. Moreover, because there is direct
negotiation between the borrower and lender, the opportunity is greater to
structure bond terms that are more favorable to the borrower than the terms
routinely contained in public debt issues.

1. Describe the primary features of the following long-term debt
• Term loan
• Bond
• First mortgage bond
• Junior mortgage
• Debenture
• Subordinated debenture
• Municipal bond
2. What are the key differences between a private placement and a public

Debt Contracts
Debt contracts, which spell out the rights of the borrower and lender(s), have
different names depending on the type of debt. The contract between the
issuer and bondholders is called an indenture. Indentures tend to be long”
some run several hundred pages in length. For other types of debt, a similar,
but much shorter, document called a loan agreement or promissory note is
used. Health services managers are most concerned about the overall cost of
debt, including administrative costs, as well as any provisions that may restrict
the business™s future actions. In this section, some relevant debt contract
features are discussed.

Restrictive Covenants
Many debt contracts include provisions, called restrictive covenants, which
are designed to protect creditors from managerial actions that would be
332 Healthcare Finance

detrimental to their best interests. For example, the indenture for Palm Coast
Medical Center™s municipal bond issues contains several restrictive covenants,
including the covenant that the issuer must maintain a minimum current ratio
of 2.0. The current ratio is de¬ned as current assets divided by current liabil-
ities, so a current ratio of 2.0 indicates that current assets are twice as large as
current liabilities. Because the current ratio measures a business™s liquidity”
the ability to meet cash obligations as they become due”a minimum current
ratio provides some assurance to bondholders that the interest and principal
payments coming due can be covered. If Palm Coast violates any of its re-
strictive covenants”say, by allowing its current ratio to drop below 2.0”it is
said to be in technical default. (“Regular” default occurs when an interest or
principal payment is not paid on time, which is called a missed payment.)

When debt is supplied by a single creditor, there is a one-to-one relationship
between the lender and borrower. However, bond issues can have thousands
of lenders, so a single voice is needed to represent bondholders. This function
is performed by a trustee, usually an institution such as a bank, which repre-
sents the bondholders and ensures that the terms of the indenture are being
carried out. The trustee is responsible for monitoring the issuer and for taking
appropriate action if a covenant violation occurs. What constitutes appropriate
action varies with the circumstances. A trustee has the power to foreclose on an
issue in default, which makes the full amount of principal and unpaid interest
due and payable immediately. However, insisting on immediate payment may
result in bankruptcy and possibly large losses on the bonds. In such a case,
the trustee may decide that the bondholders would be better served by giving
the issuer a chance to work out its problems, which would avoid forcing the
business into bankruptcy.

Call Provisions
A call provision gives the issuer the right to call a bond for redemption prior
to maturity; that is, the issuer can pay off the bondholders in entirety and
redeem, or retire, the issue. If it is used, the call provision generally states that
the ¬rm must pay an amount greater than the initial amount borrowed. The
additional sum required is de¬ned as the call premium.
Many callable bonds offer a period of call protection, which protects
investors from a call just a short time after the bonds are issued. For example,
the 20-year callable bonds issued by Vanguard Healthcare in 2003 are not
callable until 2112, which is ten years after the original issue date. This type
of call provision is known as a deferred call.
The call privilege is valuable to the issuer but potentially detrimental
to bondholders, especially if the bond is issued in a period when interest rates
are cyclically high. In general, bonds are called when interest rates have fallen
because the issuer usually replaces the old, high-interest issue with a new,
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lower-interest issue and hence reduces annual interest expense. When this
occurs, investors are forced to reinvest the principal returned in new securities
at the then current (lower) rate. As readers will see later, the added risk to
lenders of a call provision causes the interest rate on a new issue of callable
bonds to exceed that on a similar new issue of noncallable bonds.
If a bond, or other debt security, has a call provision and interest rates
drop, the issuer has to make a decision, called a refunding decision, whether or
not to call the issue. In essence, the decision involves a cost/bene¬t analysis
wherein the costs are the administrative costs associated with calling one bond
and issuing another, while the bene¬ts are lower future interest payments.3

1. Describe the following debt contract features:
• Bond indenture
• Restrictive covenant
• Trustee
• Call provision
2. What is the difference between technical default and “regular” default?
3. What impact does a call provision have on an issue™s interest rate?

Bond Ratings
Since the early 1900s, bonds have been assigned quality ratings that re¬‚ect
their probability of going into default.4 The three primary rating agencies are
Fitch Ratings, Moody™s Investors Service (Moody™s), and Standard & Poor™s
(S&P). All three agencies rate both corporate and municipal bonds. Standard
& Poor™s rating designations are shown in Table 11.1, but all three have similar
rating designations. Bonds with a BBB and higher rating are called investment
grade, while double B and lower bonds, called junk bonds, are more speculative
in nature because they have a much higher probability of going into default
than do higher rated bonds.

TABLE 11.1
Credit Risk Rating Category
Standard &
Poor™s Bond
Prime AAA
Excellent AA
Upper medium A
Lower medium BBB
Speculative BB
Very speculative B
Default D

Note: S&P uses plus and minus modi¬ers for bond ratings below triple A. Thus, A+ designates the strongest A-rated
bond and A’ the weakest.
334 Healthcare Finance

Bond Rating Criteria
Although the rating assignments are subjective, they are based on both quali-
tative characteristics, such as quality of management, and quantitative factors,
such as a business™s ¬nancial strength. Analysts at the rating agencies have
consistently stated that no precise formula is used to set a ¬rm™s rating”many
factors are taken into account, but not in a mathematically precise manner.
Statistical studies have supported this contention. Researchers who have tried
to predict bond ratings on the basis of quantitative data have had only lim-
ited success, which indicates that the agencies do indeed use a good deal of
judgment to establish a bond rating.

Importance of Bond Ratings
Bond ratings are important both to businesses and to investors. First, a bond™s
rating is an indicator of its default risk, so the rating has a direct, measurable
in¬‚uence on the interest rate required by investors and hence on the ¬rm™s cost
of debt capital. Second, most corporate (i.e., taxable) bonds are purchased by
institutional investors rather than by individuals. Many of these institutions are
restricted to investment-grade securities. Also, most individual investors who
buy municipal bonds are unwilling to take high risks in their bond purchases.
Thus, if an issuer™s bonds fall below BBB, it will be more dif¬cult to sell new
bonds because the number of potential purchasers is reduced. As a result of
their higher risk and more restricted market, low-grade bonds typically carry
much higher interest rates than do high-grade bonds. For example, in early
2004, long-term BBB-rated corporate bonds had an interest rate that was 1.1
percentage points above AAA-rate bonds, BB bonds were 1.6 points above
BBB bonds, B bonds were 4.5 points above BB bonds, and CCC bonds were
8.2 points above B bonds. Clearly, the interest rate penalty for having a low
bond rating is signi¬cant.

Changes in Ratings
A change in a ¬rm™s bond rating will have a signi¬cant effect on its ability
to borrow long-term capital and on the cost of that capital. Rating agencies
review outstanding bonds on a periodic basis, and occasionally they upgrade
or downgrade a bond as a result of the issuer™s changed circumstances. Also,
an announcement that a company plans to sell a new debt issue, or to merge
with another company and pay for the acquisition by exchanging bonds for
the stock of the acquired company, will trigger an agency review and possibly
lead to a rating change. If a ¬rm™s situation has deteriorated somewhat, but
its bonds have not been reviewed and downgraded, it may choose to use a
term loan or short-term debt rather than to ¬nance through a public bond
issue. This will perhaps postpone a rating agency review until the situation has
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1. What are the three major rating agencies?
2. What are some criteria that the rating agencies use when assigning
3. What impact do bond ratings have on the cost of debt to the issuing

Credit Enhancement
Credit enhancement, or bond insurance, which is available primarily for mu-
nicipal bonds, is a relatively recent form of insurance that upgrades a bond™s
rating to AAA. Credit enhancement is offered by several credit insurers, the
three largest being the Municipal Bond Investors Assurance (MBIA) Corpo-
ration, AMBAC Indemnity Corporation, and Financial Guaranty Insurance
Corporation, a subsidiary of General Electric Capital Corporation. Currently,
almost 60 percent of all new healthcare municipal issues carry bond insurance.
Here is how credit enhancement works. Regardless of the inherent
credit rating of the issuer, the bond insurer guarantees that bondholders will
receive the promised interest and principal payments. Thus, bond insurance
protects investors against default by the issuer. Because the insurer gives its
guarantee that payments will be made, an insured bond carries the credit rating
of the insurance company rather than that of the issuer. For example, Sabal
Palms Medical Center has an A rating, so new bonds issued by the hospital
without credit enhancement would be rated A. However, in 2003, Sabal Palms
Medical Center issued $50 million of hospital revenue bonds with an AAA
rating because of MBIA insurance.
Credit enhancement gives the issuer access to the lowest possible in-
terest rate, but not without a cost. Bond insurers typically charge an up-front
fee of about 45 to 75 basis points of the total debt service over the life of
the bond”the lower the hospital™s inherent credit rating, the higher the cost
of bond insurance. Most of the newly issued insured municipal bonds have
an underlying credit rating of AA or A. The remainder are still of investment
grade, rated BBB.

1. What does the term “credit enhancement” mean?
2. Why would healthcare issuers seek bond insurance?

Interest Rate Components
As we discussed previously, investors require compensation for time value,
in¬‚ation, and risk. The relationship is formalized for stock investments by the
Capital Asset Pricing Model (CAPM). For debt investments, the rate of return
336 Healthcare Finance

(i.e., the interest rate) required by investors consists of a base rate plus several
components. By understanding the components, it is possible to gain insights
on why interest rates change over time, differ among borrowers, and even
differ on separate issues by the same borrower.

Real Risk-Free Rate (RRF)
The base upon which all interest rates are built is the real risk-free rate (RRF).
This is the rate that investors would demand on a debt security that is totally
riskless when there is no in¬‚ation. Thus, the RRF compensates investors for
the time value of money, but considers no other factors. Although dif¬cult to
measure, the RRF is thought to fall somewhere in the range of 2 to 4 percent.
In the real world, in¬‚ation is rarely zero, and most debt securities have some
risk; thus, the actual interest rate on a given debt security will typically be
higher than the real risk-free rate.

In¬‚ation Premium (IP)
In¬‚ation has a major impact on required interest rates because it erodes the
purchasing power of the dollar and lowers the value of investment returns.
Creditors, who are the suppliers of debt capital, are well aware of the impact
of in¬‚ation. Thus, they build an in¬‚ation premium (IP ) into the interest rate
that is equal to the expected in¬‚ation rate over the life of the security.
For example, suppose that the real risk-free rate was RRF = 3%, and
that in¬‚ation was expected to be 2 percent (and hence IP = 2%) during the
next year. The rate of interest on a one-year riskless debt security would be 3%
+ 2% = 5%.
The rate of in¬‚ation built into interest rates is the rate of in¬‚ation
expected in the future, not the rate experienced in the past. Thus, the latest
reported ¬gures may show an annual in¬‚ation rate of 3 percent, but that is for
a past period. If investors expect a 2 percent in¬‚ation rate in the future, then
2 percent would be built into the current rate of interest. Also, the in¬‚ation
rate re¬‚ected in any interest rate is the average rate of in¬‚ation expected over
the life of the security. Thus, the in¬‚ation rate built into a one-year bond
is the expected in¬‚ation rate for the next year, but the in¬‚ation rate built
into a 30-year bond is the average rate of in¬‚ation expected over the next 30
years. Note that the combination of the RRF and IP is called the risk-free rate
(RF ). Thus, the risk-free rate incorporates in¬‚ation expectations, but it does
not incorporate any risk factors. In this example, RF = 5%.

Default Risk Premium (DRP)
The risk that a borrower will default (not make the promised payments) has
a signi¬cant impact on the interest rate set on a debt security. This risk,
along with the possible consequences of default, are captured by a default
risk premium (DRP ). Treasury securities have no default risk; thus, they
carry the lowest interest rates on taxable securities in the United States. For
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corporate and municipal bonds, the higher the bond™s rating, the lower its
default risk. All else the same, the lower the default risk, the lower the DRP
and interest rate.

Liquidity Premium (LP)
A liquid asset is one that can be sold quickly at a predictable fair market price,
and thus can be converted to a known amount of cash on short notice. Ac-
tive markets, which provide liquidity, exist for Treasury securities and for the
stocks and bonds of larger corporations. Securities issued by small companies,
including healthcare providers that issue municipal bonds, are illiquid”once
bought they can be resold by the owner, but not quickly and not at a pre-
dictable price. Furthermore, illiquid securities are normally dif¬cult to sell
and hence have relatively high transactions costs. (Transactions costs include
commissions, fees, and other expenses associated with selling securities.)
If a security is illiquid, investors will add a liquidity premium (LP) when
they set their required interest rate. It is very dif¬cult to measure liquidity
premiums with precision, but a differential of at least 2 percentage points is
thought to exist between the least liquid and the most liquid securities of
similar default risk and maturity.

Price Risk Premium (PRP)
As will be demonstrated later in the bond valuation section, the market value
(price) of a long-term bond declines sharply when interest rates rise. Because
interest rates can and do rise, all long-term bonds, including Treasury bonds,
have an element of risk called price risk. For example, assume an individual
bought a 30-year Treasury bond for $1,000 when the long-term interest rate
on Treasury securities was 7 percent. Then, if 10 years later T-bond rates had
risen to 14 percent, the value of the bond would have fallen to under $600.
That would represent a sizeable loss on the investment, which demonstrates
that long-term bonds”even U.S. Treasury bonds”are not riskless.
As a general rule, the bonds of any organization, from the U.S. gov-
ernment to HCA to St. Vincent™s Community Hospital, have more price risk
the longer the maturity of the bond. Therefore, a price risk premium (PRP ),
which is tied directly to the term to maturity, must be included in the interest
rate. The effect of price risk premiums is to raise interest rates on long-term
bonds relative to those on short-term bonds. This premium, like the others,
is extremely dif¬cult to measure, but it seems to vary over time; it rises when
interest rates are more volatile and uncertain and falls when they are more
stable. In recent years, the price risk premium on 30-year T-bonds appears to
have been generally in the range of 0.5 to 2 percentage points.

Call Risk Premium (CRP)
Bonds that are callable are riskier for investors than those that are non-
callable because callable bonds have uncertain maturities. Furthermore, bonds
338 Healthcare Finance

typically are called when interest rates fall, so bondholders must reinvest the
call proceeds at a lower interest rate. To compensate for bearing call risk,
investors charge a call risk premium (CRP ) on callable bonds. The amount of
the premium depends on such factors as the interest rate on the bond, current
interest rate levels, and time to ¬rst call (the call deferral period). Historically,
call risk premiums have been in the range of 30 to 50 basis points.

Combining the Components
When all the interest rate components are taken into account, the interest rate
required on any debt security can be expressed as follows:

Interest rate = RRF + IP + DRP + LP + PRP + CRP.
First consider one-year Treasury bills. Assume that RRF is 2 percent, and
in¬‚ation is expected to average 3 percent in the coming year. Because T-bills
have no default, liquidity, or call risk, and almost no price risk, the interest
rate on a one-year T-bill would be 5 percent:

Interest rateT’bill = RRF + IP + DRP + LP + PRP + CRP
= 2% + 3% + 0 + 0 + 0 + 0 = 5%.
As discussed previously, the combination of RRF and IP is the risk-fee rate,
so RF = 5%. In general, the rate of interest on short-term Treasury securities
(T-bills) is used as a proxy for the short-term risk-free rate.
Consider another illustration, the callable 30-year corporate bonds is-
sued by HealthWest Corporation. Assume that these bonds have an in¬‚ation
premium of 4 percent; default risk, liquidity, and price risk premiums of 1 per-
cent each; and a call risk premium of 40 basis points. Under these assumptions,
these bonds would have an interest rate of 9.4 percent:

Interest rate30’year bonds = RRF + IP + DRP + LP + PRP + CRP
= 2% + 4% + 1% + 1% + 1% + 0.4% = 9.4%.
When interest rates are viewed as the sum of a base rate plus premiums
for in¬‚ation and risk, it is easy to visualize the underlying economic forces that
cause interest rates to vary among different issues and over time.

Self-Test 1. Write out an equation for the required interest rate on a debt security.
Questions 2. What is the difference between the real risk-free rate, RRF, and the risk-
free rate, RF?
3. Do the interest rates on Treasury securities include a default risk
premium? A liquidity premium? A price risk premium? Explain your
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4. Why are callable bonds riskier for investors than similar bonds without a
call provision?
5. What is price risk? What type of debt securities would have the largest
price risk premium?

The Term Structure of Interest Rates
At certain times, short-term interest rates are lower than long-term rates; at
other times, short-term rates are higher than long-term rates; and at yet other
times, short-term and long-term rates are roughly equal. The relationship be-
tween long- and short-term rates, which is called the term structure of interest
rates, is important to health services managers who must decide whether to
borrow by issuing long- or short-term debt and to investors who must decide
whether to buy long- or short-term debt. Thus, it is important to understand
how interest rates on long- and short-term debt are related to one another.
To examine the current term structure, look up the interest rates on
debt of various maturities by a single issuer (usually the U.S. Treasury) in a
source such as the Wall Street Journal. For example, the tabular section of
Figure 11.1 presents interest rates for Treasury securities of different maturi-
ties on two dates. The set of data for a given date, when plotted on a graph,
is called a yield curve. As shown in the ¬gure, the yield curve changes both
in position and in shape over time. Had the yield curve been drawn during
January of 1982, it would have been essentially horizontal because long-term
and short-term bonds at that time had about the same rate of interest.
On average, long-term rates have been higher than short-term rates,
so the yield curve usually slopes upward. An upward sloping curve would be
expected if the in¬‚ation premium is relatively constant across all maturities
because the price risk premium applied to long-term issues will push long-
term rates above short-term rates. Because an upward-sloping yield curve is
most prevalent, this shape is also called a normal yield curve. Conversely, a
yield curve that slopes downward is called an inverted, or abnormal, yield
curve. Thus, the yield curve for March 1980 is inverted, but the one for March
2004 is normal.5
Figure 11.1 shows yield curves for U.S. Treasury securities, but the
curves could have been constructed for similarly rated corporate or municipal
(i.e., tax-exempt) debt, if the data were available. In each case, the yield curve
would be approximately the same shape but would differ in vertical position.
For example, had the yield curve been constructed for Beverly Enterprises,
a for-pro¬t nursing home operator, it would fall above the Treasury curve
because interest rates on corporate debt include default risk premiums, while
Treasury rates do not. Conversely, the curve for Baptist Medical Center, a not-
for-pro¬t hospital, would probably fall below the Treasury curve because the
tax-exemption bene¬t, which lowers the interest rate on tax-exempt securities,
340 Healthcare Finance

U.S. Treasury
Interest Rate
Debt Interest (%)
Rates on Two
Yield curve for March 1980
(current rate of inflation: 12%)



Yield curve for March 2004
(current rate of inflation: 1%)



1 5 10 20
Years to Maturity

Interest Rate
Term to Maturity March 1980 March 2004

6 months 15.0% 1.0%
1 year 14.0 1.3
5 years 13.5 3.2
10 years 12.8 4.2
20 years 12.5 5.0

generally outweighs the default risk premium. In every case, however, the
riskier the issuer (i.e., the lower the debt is rated), the higher the yield curve
plots on the graph.
Health services managers use yield curve information to help make
decisions regarding debt maturities. To illustrate, assume for the moment that
it is March 2004, and that the yield curve for that month in Figure 11.1 applies
to Baptist Medical Center. Now, assume that the hospital plans to issue $10
million of debt to ¬nance a new outpatient clinic with a 30-year life. If it
borrowed in 2004 on a short-term basis”say for one year”Baptist™s interest
cost for that year would be 1.0 percent, or $100,000. If it used long-term
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(20-year) ¬nancing, its cost would be 5.0 percent, or $500,000. Therefore,
at ¬rst glance, it would seem that Baptist should use short-term debt.
However, if the hospital uses short-term debt, it will have to renew
the loan every year at the then current short-term rate. Although unlikely,
it is possible that interest rates could soar to 1980 levels. If this happened,
by 2010 or so the hospital might be paying 14 percent, or $1.4 million, per
year. Conversely, if Baptist used long-term ¬nancing in 2004, its interest costs
would remain constant at $500,000 per year, so an increase in interest rates
in the economy would not hurt the hospital.
Financing decisions would be easy if managers could accurately forecast
interest rates. Unfortunately, predicting future interest rates with consistent
accuracy is somewhere between dif¬cult and impossible”people who make
a living by selling interest rate forecasts say it is dif¬cult, but many others
say it is impossible. Sound ¬nancial policy, therefore, calls for using a mix
of long- and short-term debt, as well as equity, in such a manner that the
business can survive in all but the most severe, and hence unlikely, interest
rate environments. Furthermore, the optimal ¬nancing policy depends in an
important way on the maturities of the ¬rm™s assets: In general, to reduce risk,
managers try to match the maturities of the ¬nancing with the maturities of
the assets being ¬nanced. This issue will be addressed again in Chapter 16
when current asset ¬nancing policies are discussed.

1. What is a yield curve and what information is needed to create this
2. What is the difference between a normal yield curve and an abnormal
3. If short-term rates are lower than long-term rates, why may a business
still choose to ¬nance with long-term debt?
4. Explain the following statement: “A ¬rm™s ¬nancing policy depends in
large part on the nature of its assets.”

Debt Valuation
Now that the basics of long-term debt ¬nancing have been discussed, the next
step is to understand how investors value debt securities. Security valuation
concepts are important to health services managers for many reasons. Here
are just a few:

• The lifeblood of any business is capital. In fact, one of the most common
reasons for business failures is insuf¬cient capital. Therefore, it is vital that
managers understand how investors make investment decisions.
• For investor-owned ¬rms, stock price maximization is the primary goal,
342 Healthcare Finance

so managers of for-pro¬t ¬rms must know how investors value the ¬rm™s
securities to understand how managerial actions affect stock price.
• For health services managers to make ¬nancially sound decisions regarding
real-asset (e.g., plant and equipment) investments, it is necessary to
estimate the business™s cost of capital. Security valuation is a necessary skill
in this process, which is covered in detail in Chapter 13.
• Real assets are valued in the same general way as securities. Thus, security
valuation provides managers with an excellent foundation to learn
real-asset valuation, the heart of capital investment decision making within
health services organizations. The concepts presented here are crucial to a
good understanding of Chapters 14 and 15.

General Valuation Model
In the ¬nancial sense, the value of any asset (investment) stems from the same
source: the cash ¬‚ows that the asset is expected to produce. Thus, all assets
are valued ¬nancially in the same way:

• Estimate the expected cash ¬‚ow stream. Estimating the cash ¬‚ow stream
involves estimating the expected cash ¬‚ow in each period during the life of
the asset. For some assets, such as Treasury securities, the estimation
process is quite easy because the interest and principal repayment stream is
speci¬ed by contract. For other assets, such as the stock of a biotechnology
start-up company that is not yet paying dividends or a healthcare
provider™s new service line, the estimation process can be very dif¬cult.
• Assess the riskiness of the stream. The next step is to assess the riskiness
of the cash ¬‚ows. The cash ¬‚ows of most assets are not known with
certainty but are best represented by probability distributions. The more
uncertain these distributions, the greater the riskiness of the cash ¬‚ow
stream. Again, in some situations it will be fairly easy to assess the riskiness
of the estimated cash ¬‚ow stream; in other situations it may be quite
• Set the required rate of return. The required rate of return on the cash
¬‚ow stream is established on the basis of the stream™s riskiness and the
returns available on alternative investments of similar risk. In essence, the
opportunity cost principle discussed in Chapter 9 is applied here. By
investing in one asset, the funds are no longer available for alternative
investments. This opportunity cost sets the required rate of return on the
asset being valued.
• Discount and sum the expected cash ¬‚ows. Each expected cash ¬‚ow is
now discounted at the asset™s required rate of return and the present
values are summed to ¬nd the value of the asset.

The following time line formalizes the valuation process:
C h a p t e r 1 1 : Lo n g - Te r m D e b t F i n a n c i n g

0 R(R) 1 2 3 N“1 N
... ...
E(CF1) E(CF2) E(CF3) E(CFN“1) E(CFN)

Here, E(CFt) is the expected cash ¬‚ow in each Period t, R(R) is the required
rate of return (i.e., the opportunity cost rate) on the asset, and N is the number
of periods for which cash ¬‚ows are expected. The periods can be months,
quarters, semiannual periods, or years, depending on the frequency of the
cash ¬‚ows expected from the asset.
The general valuation model can be applied to both ¬nancial assets (se-
curities ), such as stocks and bonds, and real (physical ) assets, such as buildings,
equipment, and even whole businesses. Each asset type requires a somewhat
different application of the general valuation model, but the basic approach
remains the same. In this chapter, the general valuation model is applied to
debt securities (bonds). In the chapters that follow, the model is applied to
stocks and to real assets.

We will use bonds to illustrate debt valuation, although the techniques used
are applicable to most types of debt. To begin, here are some required de¬ni-

• Par value. The par value, also called par, is the stated (face) value of the
bond. It is often set at $1,000 or $5,000. The par value generally
represents the amount of money the business borrows (per bond) and
promises to repay at some future date.
• Maturity date. Bonds generally have a speci¬ed maturity date on which
the par value will be repaid. For example, Big Sky Healthcare, a for-pro¬t
hospital system, issued $50 million worth of $1,000 par value bonds on
January 1, 2004. The bonds will mature on December 31, 2018, so they
had a 15-year maturity at the time they were issued. The effective maturity
of a bond declines each year after it was issued. Thus, at the beginning of
2005, Big Sky™s bonds will have a 14-year maturity, and so on.
• Coupon rate. A bond requires the issuer to pay a speci¬c amount of
interest each year or, more typically, each six months. The rate of interest
is called the coupon interest rate, or just coupon rate. The rate may be
variable, in which case it is tied to some index, such as 2 percentage points
above the prime rate. More commonly, the rate will be ¬xed over the life
344 Healthcare Finance

(maturity) of the bond. For example, Big Sky™s bonds have a 10 percent
coupon rate, so each $1,000 par value bond pays 0.10 — $1,000 = $100
in interest each year. The dollar amount of annual interest, in this case
$100, is called the coupon payment.6
• New issues versus outstanding bonds. A bond™s value is determined by
its coupon payment”the higher the coupon payment, other things held
constant, the higher its value. At the time a bond is issued, its coupon rate
is generally set at a level that will cause the bond to sell at its par value. In
other words, the coupon rate is set at the rate that investors require to buy
the bond (i.e., the going rate). A bond that has just been issued is called a
new issue. After the bond has been on the market for about a month it is
classi¬ed as an outstanding bond, or a seasoned issue. New issues sell close
to par, but because a bond™s coupon payment is generally ¬xed, changing
economic conditions (and hence interest rates) will cause a seasoned bond
to sell for more or less than its par value.
• Debt service requirement. Firms that issue bonds are concerned with
their total debt service requirement, which includes both interest expense
and repayment of principal. For Big Sky, the debt service requirement
(payment) is 0.10 — $50 million = $5 million per year until maturity. In
2018, the ¬rm™s debt service requirement will be $5 million in interest
plus $50 million in principal repayment. Thus, the total debt service
requirement on the issue is (15 — $5) + $50 = $125 million. In Big Sky™s
case, only interest is paid until maturity, so the entire principal amount
must be repaid at that time. As discussed earlier, many municipal bonds
are serial issues structured so that the debt service requirements are
relatively constant over time. In this situation, the issuer pays back a
portion of the principal during each year.

The Basic Bond Valuation Model
Bonds typically call for the payment of a speci¬c amount of interest for a
speci¬c number of years, and for the repayment of par on the bond™s maturity
date. Thus, a bond represents an annuity plus a lump sum, and its value is
found as the present value of this cash ¬‚ow stream. Here are the cash ¬‚ows
from Big Sky™s bonds on a time line:
0 1 2 13 14 15
.. .
$100 $100 $100 $100 $ 100

If the bonds had just been issued, and the coupon rate was set at the current
interest rate for bonds of this risk, then the required rate of return on the
bonds, R(Rd), would be 10 percent. Because the value of a bond is merely the
present value of the bond™s cash ¬‚ows, discounted to Time 0 at a 10 percent
discount rate, the value of the bond at issue was $1,000:
C h a p t e r 1 1 : Lo n g - Te r m D e b t F i n a n c i n g

Present value of a 15-year, $100 payment annuity at 10 percent = $ 760.61
Present value of a $1,000 lump sum discounted 15 years = 239.39
Value of bond = $1,000.00

The value of the bond can be found using a ¬nancial calculator as
’100 ’1000
Inputs 15 10

= 1,000

Note that the cash ¬‚ows were treated as out¬‚ows so that the value would be
displayed as a positive number. Also, in bond valuation, all ¬ve time-value-of-
money keys on a ¬nancial calculator are used because bonds involve both an
annuity and a lump sum.
If R(Rd) remained constant at 10 percent over time, what would be the
value of the bond one year after it was issued? Now, the term to maturity is
only 14 years”that is, N = 14. As seen below, the bond™s value remains at
’100 ’1000
Inputs 14 10

= 1,000

As long as the required rate of return remains at 10 percent, the bond™s value
remains at par, or $1,000.
Suppose that interest rates in the economy fell after the bonds were
issued, and, as a result, R(Rd) decreased from 10 percent to 5 percent. The
coupon rate and par value are ¬xed by contract, so they remain unaffected by
changes in interest rates, but now the discount rate is 5 percent rather than
10 percent. At the end of the ¬rst year, with 14 years remaining, the value of
the bond would be $1,494.93:
’100 ’1000
Inputs 14 5

= 1,494.93

The arithmetic of the bond value increase should be clear (lower dis-
count rates lead to higher present values), but what is the underlying eco-
nomic logic? The fact that interest rates have fallen to 5 percent means that if
an individual had $1,000 to invest, he or she could buy new bonds like Big
Sky™s (every day some 10 to 20 companies sell new bonds), except that these
346 Healthcare Finance

new bonds would only pay $50 in interest each year. Naturally, the individual
would favor an annual payment of $100 over one of $50 and hence would
be willing to pay more than $1,000 for Big Sky™s bonds. All investors would
recognize this; as a result, the Big Sky bonds would be bid up in price to
$1,494.93, at which point they would provide the same rate of return as new
bonds of similar risk”5 percent.
Assuming that interest rates stay constant at 5 percent over the next
14 years, what would happen to the value of a Big Sky bond? It would fall
gradually from $1,494.93 at present to $1,000 at maturity, when the company
will redeem each bond for $1,000. This point can be illustrated by calculating
the value of the bond one year later, when it has only 13 years remaining to

’100 ’1000
Inputs 13 5

= 1,469.68

The value of the bond with 13 years to maturity is $1,469.68.
If an individual purchased the bond at a price of $1,494.93, and then
sold it one year later with interest rates still at 5 percent, he or she would have
a capital loss of $25.25. The rate of return on the bond over the year consists
of an interest, or current, yield plus a capital gains yield:

= $100/$1,494.93 = 0.0669 =
Current yield 6.69%
= ’$25.25/$1,494.93 = ’0.0169 = ’1.69%
Capital gains yield
= $74.75/$1,494.93 = 0.0500 =
Total rate of return, or yield 5.00%

Had interest rates risen from 10 to 15 percent during the ¬rst year after
issue rather than fallen, the value of Big Sky™s bonds would have declined
to $713.78 at the end of the ¬rst year. If interest rates held constant at 15
percent, the bond would have a value of $720.84 at the end of the second
year, so the total yield to investors would be:

= $100/$713.78 = 0.1401 = 14.01%
Current yield
= $7.06/$713.78 = 0.0099 =
Capital gains yield 0.99%
= $107.06/$713.78 = 0.1500 = 15.00%
Total rate of return, or yield

Figure 11.2 graphs the values of the Big Sky bond over time, assuming
that interest rates will remain constant at 10 percent, fall to 5 percent and then
remain at that level, and rise to 15 percent and remain constant at that level.
The ¬gure illustrates the following important points:

• Whenever the required rate of return on a bond equals its coupon rate,
the bond will sell at its par value.
• When interest rates, and hence required rates of return, fall after a bond is


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