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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

FIGURE 11.2
Time Path of the
Bond Value
Time path of bond value when R(R d ) = 5% Value of a
(\$)
1,495
Coupon, \$1,000
Par Value Bond
Time path of bond value when R(R d ) = 10% M When Interest
M = 1,000
(par bond)
Rates are 5%,
714 10%, and 15%
Time path of bond value when R(R d ) = 15%
(discount bond)

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Years

Bond Value at a Required Rate of Return of
Year 5% 10% 15%

0 ā” \$1,000.00 ā”
1 \$1,494.93 1,000.00 \$ 713.78
2 1,469.68 1,000.00 720.84
3 1,443.16 1,000.00 728.97
. . . .
. . . .
. . . .
13 1,092.97 1,000.00 918.71
14 1,047.62 1,000.00 956.52
15 1,000.00 1,000.00 1,000.00

issued, the bondā™s value rises above its par value, and the bond sells at a
ā¢ When interest rates, and hence required rates of return, rise after a bond is
issued, the bondā™s value falls below its par value, and the bond sells at a
discount.
ā¢ Bond prices on outstanding issues and interest rates are inversely related.
increasing prices.
ā¢ The price of a bond will always approach its par value as its maturity date
approaches, provided the issuer does not default on the bond.

Note, however, that interest rates do not remain constant over time, so in
reality a bondā™s price ļ¬‚uctuates both as interest rates in the economy ļ¬‚uctuate
348 Healthcare Finance

and the bondā™s term to maturity decreases. In addition, a bondā™s price will
change if there is a change in the creditworthiness of the issuer.

Yield to Maturity on a Bond
Up to this point, a bondā™s required rate of return and cash ļ¬‚ows have been
used to determine its value. In reality, investorsā™ required rates of return on
securities are not observable, but security prices can be easily determined, at
least on those securities that are actively traded, by looking in the Wall Street
Journal or by using some other data source. Suppose that the Big Sky bond
had 14 years remaining to maturity, and the bond was selling at a price of
\$1,494.93. What rate of return, or yield to maturity (YTM), would be earned
if the bond was bought at this price and held to maturity? To ļ¬nd the answer,
5 percent, use a ļ¬nancial calculator as follows:

ā’100 ā’1000
Inputs 14 1494.93

= 5.00
Output

The YTM is the expected rate of return on a bond, assuming it is held to
maturity and no default occurs. It is similar to the total rate of return discussed
in the previous section. For a bond that sells at par, the YTM consists entirely
of an interest yield, but if the bond sells at a discount or premium, the YTM
consist of the current yield plus a positive or negative capital gains yield.
Bonds that are callable have both a YTM and a yield to call (YTC). The
YTC is the expected rate of return on the bond assuming it will be called and
assuming that the probability of default is zero. The YTC is calculated like the
YTM, except that N reļ¬‚ects the number of years until the bond will be called,
as opposed to years to maturity, and M reļ¬‚ects the call price rather than the
maturity value.

Bond Values with Semiannual Compounding
Virtually all bonds issued in the United States actually pay interest semiannu-
ally, or every six months. To apply the preceding valuation concepts to semi-
annual bonds, the bond valuation procedures must be modiļ¬ed as follows:

ā¢ Divide the annual interest payment, INT, by two to determine the dollar
amount paid each six months.
ā¢ Multiply the number of years to maturity, N, by two to determine the
number of semiannual interest periods.
ā¢ Divide the annual required rate of return, R(Rd), by two to determine the
semiannual required rate of return.

To illustrate the use of the semiannual bond valuation model, assume
that the Big Sky bonds pay \$50 every six months rather than \$100 annually.
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Thus, each interest payment is only half as large, but there are twice as many
of them. When the going rate of interest is 5 percent annually, the value of
Big Skyā™s bonds with 14 years left to maturity is \$1,499.12:
ā’50 ā’1000
Inputs 28 2.5

= 1,499.12
Output

Similarly, if the bond were actually selling for \$1,400 with 14 years to
maturity, its YTM would be 5.80 percent:
ā’50 ā’1000
Inputs 28 1400

= 2.90
Output

The value for I, 2.90 percent, is the periodic (semiannual) YTM, so it is
necessary to multiply it by two to get the annual YTM. It is convention in
the bond markets to quote all rates on a stated annual basis, which is ļ¬ne
when bondsā”all of which have semiannual couponsā”are being compared.
However, when the returns on securities that have different periodic pay-
ments are being compared, all rates of return should be expressed as effective
annual rates.7
Interest Rate Risk
Interest rates change over time, which causes two types of risk that fall un-
der the general classiļ¬cation of interest rate risk. First, as illustrated in our
discussion of bond valuation, an increase in interest rates leads to a decline
in the values of outstanding bonds. Because interest rates can increase at any
time, bondholders face the risk of losses on their holdings. This risk is called
price risk. Second, many bondholders buy bonds to build funds for future use.
These bondholders reinvest the interest (and perhaps principal) cash ļ¬‚ows as
they are received. If interest rates fall, bondholders will earn a lower rate on
the reinvested cash ļ¬‚ows, which will have a negative impact on the future value
of their holdings. This risk is called reinvestment rate risk.
An investorā™s exposure to price risk depends on the maturity of the
bonds. To illustrate, Figure 11.3 shows the values of \$1,000 par value bonds
with one-year and 14-year maturities at several different market interest rates.
Notice how much more sensitive the price of the 14-year bond is to changes
in interest rates. In general, the longer the maturity of the bond, the greater
its price change in response to a given change in interest rates. Thus, bonds
with longer maturities are exposed to more price risk.
Although a one-year bond exposes the buyer to less price risk than a
14-year bond, the one-year bond carries with it more reinvestment rate risk.
350 Healthcare Finance

FIGURE 11.3
Value of
Long-Term and
Short-Term 10%
Annual Coupon
Rate Bonds at
Different Market
Interest Rates

Bond Value
Current Market
Interest Rate 1-Year Bond 14-Year Bond

2.5% \$1,073.17 \$1,876.82
5.0 1,047.62 1,494.93
7.5 1,023.26 1,212.23
10.0 1,000.00 1,000.00
12.5 977.78 838.45
15.0 956.52 713.78
17.5 936.17 616.25

If the holding period is more than one year, the principal and interest will
have to be reinvested after one year. If interest rates fall, the return earned
during the second year will be less than the return earned during the ļ¬rst
year. Reinvestment rate risk is the second dimension of interest rate risk.
Clearly, bond investors face both price risk and reinvestment rate risk as
a result of interest rate ļ¬‚uctuations over time. Which risk is most meaningful to
a particular investor depends on the circumstances, but in general, interest rate
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risk, including both price and reinvestment rate risk, is reduced by matching
the maturity of the bond with the investorā™s investment horizon, or holding
period. For example, suppose Hilldale Community Hospital received a \$5
million contribution that it will use in ļ¬ve years to build a new neonatal care
center. By investing the contribution in ļ¬ve-year bonds, the hospital would
minimize its interest rate risk because it would be matching its investment
horizon. Price risk would be minimized because the bond will mature in
ļ¬ve years, and hence investors will receive par value regardless of the level
of interest rates at that time. Reinvestment rate risk is also minimized because
only the interest on the bond would have to be reinvested during the life of
the bond, which is a less risky situation than if both principal and interest had
to be reinvested.8

Self-Test
1. What is the general valuation model?
Questions
2. How are bonds valued?
3. What is meant by a bondā™s yield to maturity (YTM)? Its yield to call
(YTC)?
4. Differentiate between price risk and reinvestment rate risk.

Key Concepts
This chapter provides an overview of long-term debt ļ¬nancing, including
how interest rates are determined, the characteristics of the major types of
debt securities, and how such securities are valued. The key concepts of this
chapter are:
ā¢ Any business must have assets if it is to operate and, in order to acquire
assets, the business must raise capital. Capital comes in two basic forms,
debt and equity ( or fund) capital.
ā¢ Capital is allocated through the price system; a price is charged to ārentā
money. Lenders charge interest on funds they lend, while equity investors
receive dividends and capital gains in return for letting the ļ¬rm use their
money.
ā¢ Four fundamental factors affect the cost of money: investment
opportunities, time preferences for consumption, risk, and inļ¬‚ation.
ā¢ Term loans and bonds are long-term debt contracts under which a
borrower agrees to make a series of interest and principal payments on
speciļ¬c dates to the lender. A term loan is generally sold to one (or a few)
lenders, while a bond is typically offered to the public and sold to many
different investors.
ā¢ In general, debt is categorized as Treasury, which is debt issued by the
federal government; corporate, which is debt issued by taxable businesses;
and municipal, which is debt issued by non-federal governmental entities,
including debt issued on behalf of not-for-proļ¬t healthcare providers.
352 Healthcare Finance

ā¢ Many different types of corporate and municipal bonds exist, including
mortgage bonds, debentures, and subordinated debentures. Prevailing
interest rates, the bondā™s riskiness, and tax consequences determine the
return required on each type of bond.
ā¢ Revenue bonds are municipal bonds in which the revenues derived from
such projects as roads or bridges, airports, water and sewage systems, and
not-for-proļ¬t healthcare facilities are pledged as security for the bonds.
ā¢ A bondā™s indenture (or a term loanā™s agreement ) is a legal document that
spells out the rights of both lenders and borrowers.
ā¢ A trustee is assigned to make sure that the terms of a bond indenture are
carried out.
ā¢ Bond indentures typically include restrictive covenants, which are
provisions designed to protect bondholders against detrimental
managerial actions.
ā¢ A call provision gives the issuer the right to redeem the bonds prior to
maturity under speciļ¬ed terms, usually at a price greater than the maturity
value (the difference is a call premium). A ļ¬rm will call a bond issue and
refund it if interest rates fall sufļ¬ciently after the bond has been issued.
ā¢ Bonds are assigned ratings that reļ¬‚ect the probability of their going into
default. The higher a bondā™s rating, and the greater the probability of
recovering bondholder capital should default occur, the lower its interest
rate.
ā¢ Credit enhancement, or bond insurance, upgrades a municipal bond rating
to AAA regardless of the inherent credit rating of the issuer. In essence,
the bond insurer guarantees that bondholders will receive the promised
interest and principal payments, even if the issuer defaults.
ā¢ The interest rate required on a debt security is composed of the real
risk-free rate (RRF) plus premiums that reļ¬‚ect inļ¬‚ation (IP), default risk
(DRP), liquidity (LP), price risk (PRP), and call risk (CRP):

Interest rate = RRF + IP + DRP + LP + PRP + CRP.
ā¢ The relationship between the yield and the term to maturity on a security
is known as the term structure of interest rates. The yield curve is a graph of
this relationship.
ā¢ Bonds call for the payment of a speciļ¬c amount of interest for a speciļ¬c
number of years and for the repayment of par on the bondā™s maturity date.
Like most assets, a bondā™s value is simply the present value of the expected
cash ļ¬‚ow stream.
ā¢ The annual rate of return on a bond consists of an interest, or current,
yield plus a capital gains yield. Assuming constant interest rates, a bond
selling at a discount will have a positive capital gains, while a bond selling
at a premium will have a negative capital gains yield.
ā¢ A bondā™s yield to maturity (YTM) is the rate of return earned on a bond if
353
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it is held to maturity and no default occurs. The YTM for a bond that sells
at par consists entirely of an interest yield, but if the bond sells at a
discount or premium, the YTM consists of the current yield plus a positive
or negative capital gains yield.
ā¢ Bondholders face price risk because bond values change when interest
rates change. An investorā™s exposure to price risk depends on the maturity
of the bonds.
ā¢ Bondholders face reinvestment rate risk when the investment horizon
exceeds the maturity of the bond issue.

Long-term debt is a major source of capital for health services organizations.
Thus, it is necessary for health services managers to be familiar with debt
concepts. Furthermore, learning how to value long-term debt provides an
excellent introduction to asset valuation. The topics covered in this chapter
will be useful throughout the remainder of the book.

Questions
11.1 The four fundamental factors that affect the supply of and demand
for investment capital, and hence interest rates, are productive
opportunities, time preferences for consumption, risk, and inļ¬‚ation.
Explain how each of these factors affects the cost of money.
11.2 The interest rate required by investors on a debt security can be
expressed by the following equation:

Interest rate = RRF + IP + DRP + LP + PRP + CRP.
Deļ¬ne each term of the equation, and explain how it affects the interest
rate.
11.3 a. What is a yield curve?
b. Is the yield curve static, or does it change over time?
c. What is the difference between a normal yield curve and an inverted
yield curve?
d. What impact does the yield curve have on debt ļ¬nancing decisions?
11.4 Brieļ¬‚y describe the following types of debt:
a. Term loan
b. Bond
c. Mortgage bond
d. Senior debt; junior debt
e. Debenture
f. Subordinated debenture
g. Municipal bond
11.5 Brieļ¬‚y explain the following debt features:
a. Indenture
354 Healthcare Finance

b. Restrictive covenant
c. Trustee
d. Call provision
ā¢ What are the three primary bond rating agencies?
11.6 a.
ā¢ What do bond ratings measure?
ā¢ How do investors interpret bond ratings?
ā¢ What is the difference between an A-rated bond and a B-rated
bond?
b. ā¢ Why are bond ratings important to investors?
ā¢ Why are ratings important to businesses that issue bonds?
11.7 What is credit enhancement?
11.8 a. What is price risk?
b. What is reinvestment rate risk?
11.9 State whether this statement is true or false: āThe values of outstanding
bonds change whenever the going rate of interest changes. In general,
short-term interest rates are more volatile than long-term rates, so
short-term bond prices are more sensitive to interest rate changes than

Problems
11.1 Assume Venture Healthcare sold bonds that have a ten-year maturity, a
12 percent coupon rate with annual payments, and a \$1,000 par value.
a. Suppose that two years after the bonds were issued, the required
interest rate fell to 7 percent. What would be the bondsā™ value?
b. Suppose that two years after the bonds were issued, the required
interest rate rose to 13 percent. What would be the bondsā™ value?
c. What would be the value of the bonds three years after issue in each
scenario above, assuming that interest rates stayed steady at either 7
percent or 13 percent?
11.2 Twin Oaks Health Center has a bond issue outstanding with a coupon
rate of 7 percent and four years remaining until maturity. The par value
of the bond is \$1,000, and the bond pays interest annually.
a. Determine the current value of the bond if present market conditions
justify a 14 percent required rate of return.
b. Now, suppose Twin Oaksā™ four-year bond had semiannual coupon
payments. What would be its current value? (Assume a 7 percent
semiannual required rate of return. However, the actual rate would
be slightly less than 7 percent because a semiannual coupon bond is
slightly less risky than an annual coupon bond.)
c. Assume that Twin Oaksā™ bond had a semiannual coupon but 20
years remaining to maturity. What is the current value under these
conditions? (Again, assume a 7 percent semiannual required rate of
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return, although the actual rate would probably be greater than 7
percent because of increased price risk.)
11.3 Tidewater Home Health Care, Inc., has a bond issue outstanding with
eight years remaining to maturity, a coupon rate of 10 percent with
interest paid annually, and a par value of \$1,000. The current market
price of the bond is \$1,251.22.
a. What is the bondā™s yield to maturity?
b. Now, assume that the bond has semiannual coupon payments. What
is its yield to maturity in this situation?
11.4 Paciļ¬c Homecare has three bond issues outstanding. All three bonds
pay \$100 in annual interest plus \$1,000 at maturity. Bond S has a
maturity of ļ¬ve years, Bond M has a 15-year maturity, and Bond L
matures in 30 years.
a. What is the value of each of these bonds when the required interest
rate is 5 percent, 10 percent, and 15 percent?
b. Why is the price of Bond L more sensitive to interest rate changes
than the price of Bond S?
11.5 Minneapolis Health System has bonds outstanding that have four
years remaining to maturity, a coupon interest rate of 9 percent paid
annually, and a \$1,000 par value.
a. What is the yield to maturity on the issue if the current market price
is \$829?
b. If the current market price is \$1,104?
c. Would you be willing to buy one of these bonds for \$829 if you
required a 12 percent rate of return on the issue? Explain your
11.6 Six years ago, Bradford Community Hospital issued 20-year municipal
bonds with a 7 percent annual coupon rate. The bonds were called
for each bond. What is the realized rate of return for those investors
who bought the bonds for \$1,000 when they were issued?
11.7 Regal Health Plans issued a ten-year, 12 percent annual coupon bond
a few years ago. The bond now sells for \$1,100. The bond has a call
provision that allows Regal to call the bond in four years at a call price
of \$1,060.
a. What is the bondā™s yield to maturity?
b. What is the bondā™s yield to call?

Notes
1. The prime rate is the interest rate that banks charge their very best (most
creditworthy) customers. Theoretically, the prime rate is set separately by every
bank, but in practice all banks follow the lead of the major New York City banks,
so there usually is a single prime rate in the United States. The prime rate is
356 Healthcare Finance

changed, sometimes quite rapidly, in response to changing inļ¬‚ation expectations
and Federal Reserve actions. In August 2004, after a series of interest rate cuts
by the Fed, the prime rate stood at 4.25 percent, its lowest level since 1958.
2. Treasury bonds, or T-bonds, have original maturities at issue greater than 10 years.
The Treasury also issues notes, called T-notes, which have maturities of two to ten
years, and bills, called T-bills, which have maturities of one year or less. Note that
the names of Treasury securities are ļ¬xed at issue even though their maturities
shorten over time. Thus, a 20-year T-bond that was issued 15 years ago now has
only ļ¬ve years remaining to maturity, but it is still classiļ¬ed as a bond, not a note.
3. For more information on the refunding decision, see Louis C. Gapenski,
Understanding Healthcare Financial Management (Chicago: Health
4. Although we focus on bond ratings here, the rating agencies also assign ratings
to other types of debt as well as to entire companies.
5. For a discussion of the forces that inļ¬‚uence the shape of the yield curve, see
Eugene F. Brigham and Michael C. Ehrhardt, Financial Management: Theory
and Practice (Fort Worth, TX: Harcourt College Publishers, 2002), Chapter 5.
6. The term coupon goes back to the time when all bonds were bearer bonds. Such
bonds had small coupons attached, one for each interest payment. To collect an
interest payment, bondholders would remove (i.e., āclipā) a coupon and send it
to the issuer, or take it to a bank, where it would be exchanged for the dollar
payment. Today, all bonds are registered bonds, and the issuer (through an agent )
automatically sends interest payments to the registered owner.
The effective annual YTM on the bond is (1.029)2 ā’ 1.0 = 1.0588 ā’ 1.0 =
7.
0.0588 = 5.88%, as compared with the stated rate of 5.80%.
8. Note that reinvestment rate risk could be eliminated if Hilldale purchased
ļ¬ve-year zero coupon bonds, which pay no interest but sell at a discount when
issued.

References
Aderholdt, J. M., and C. R. Pardue. 1989. āA Guide to Taxable Debt Financing
Alternatives.ā Healthcare Financial Management (July): 58ā“66.
Carlile, L. L., and B. M. Serchuk. 1995. āThe Coming Changes in Tax-Exempt Health
Care Finance.ā Journal of Health Care Finance (Fall): 1ā“42.
Carpenter, C. E., M. J. McCue, and S. Moon. 2003. āThe Hospital Bond Market and
the AHERF Bankruptcy.ā Journal of Health Care Finance (Summer): 17ā“28.
Carpenter, C. E., M. J. McCue, and J. B. Hossack. 2001. āAssociation of Bond,
Market, Operational, and Financial Factors with Multi-Hospital System Bond
Issues.ā Journal of Health Care Finance (Winter): 26ā“34.
Culler, S. D. 1993. āAssessing Hospital Credit Risk: A Bankerā™s View.ā Topics in
Health Care Financing (Summer): 35ā“43.
. 1993. āA Creditorā™s Perspective on the Hospital Industry.ā Topics in Health
Care Financing (Summer): 12ā“20.
Demby, H. J. 1995. āOvercoming Financial Challenges with Bond Insurance.ā
Healthcare Financial Management (March): 48ā“49.
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Galtney, B. 2000. āCapital Financing Options for Group Practices.ā Healthcare Fi-
nancial Management (May): 86ā“88.
Harris, J. P., and J. B. Price. 1988. āFinding Money Under Your Nose Using New
Capital Techniques.ā Healthcare Financial Management (July): 24ā“30.
HFMA. 2003. āHow Are Hospitals Financing the Future? Access to Capital in Health
Care Today.ā Healthcare Financial Management (November): 51ā“53.
Kaufman, K., and M. L. Hall. 1990. The Capital Management of Health Care Orga-
LeBuhn, J. 1994. āPrimary Market Derivatives: Satisfying Investor Appetites.ā Jour-
nal of Health Care Finance (Winter): 11ā“21.
Lough, S. B. 2000. āSome Tax-Exempt Bond Issues Could Become Taxable.ā Health-
care Financial Management (December): 37ā“40.
Nemes, J. 1991. āDealing with the Authorities.ā Modern Healthcare (October 14):
22ā“29.
Odegard, B. M. 1988. āTax-Exempt Financing Under the Tax Reform Act of 1986.ā
Topics in Healthcare Financing (Summer): 35ā“45.
Prince, T. R., and R. Ramanan. 1994. āBond Ratings, Debt Insurance, and Hospital
Operating Performance.ā Topics in Health Care Financing (Fall): 36ā“50.
Rosenthal, R. A., and G. P. Nelson. 2003. āSelling Real Estate to Meet Capital Needs.ā
Healthcare Financial Management (May): 50ā“52.
Smith, S. D. 1994. āThe Use of Interest Rate Swaps in Hospital Capital Finance.ā
Journal of Health Care Finance (Winter): 35ā“44.
Sterns, J. B. 1994. āEmerging Trends in Health Care Finance.ā Journal of Health
Care Finance (Winter): 1ā“10.
Wareham, T. L. 2004. āA Capital Idea: Bonds and Nontraditional Financing Op-
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Woodward, M. A. 1993. āInterest Rate Swaps: Financial Tool of the ā™90s.ā Healthcare
Financial Management (November): 56ā“64.
CHAP TER

12
EQUITY FINANCING

Learning Objectives
After studying this chapter, readers will be able to:

ā¢ Describe the key features associated with equity ļ¬nancing.
ā¢ Discuss the investment banking process.
ā¢ Conduct simple valuation analyses of common stock.
ā¢ Explain the concepts of market equilibrium and efļ¬ciency.

Introduction
Long-term debt ļ¬nancing was discussed in Chapter 11, including how in-
terest rates are set in the economy; the features of various long-term debt
securities; and how debt securities, particularly bonds, are valued. The second
primary source of capital to healthcare businesses is equity ļ¬nancing. Within
investor-owned, or for-proļ¬t, ļ¬rms, equity ļ¬nancing is obtained from share-
holders through the sale of common stock and by retaining earnings within the
business.1 The equivalent ļ¬nancing in not-for-proļ¬t ļ¬rms, which is sometimes
called fund capital, is raised through contributions, grants, and by retaining
earnings. From a ļ¬nancial perspective, common stock and fund ļ¬nancing serve
the same basic purpose, so the generic term equity will be used to refer to all
nonliability capital, regardless of a businessā™s ownership.
In this chapter, we cover the same general issues as in Chapter 11, but
the focus here is on equity rather than debt ļ¬nancing. In addition, supplemen-
tal information is provided on how securities are sold (the investment banking
process) and market efļ¬ciency.

In for-proļ¬t businesses, equity ļ¬nancing is supplied by the owners of the
business, either directly through the purchase of an equity interest in the
business or indirectly through earnings retention. Because most large for-
proļ¬t businesses are organized as corporations, the discussion here focuses
on corporate stockholders as opposed to proprietors or partners, although
many of the concepts apply to all owners.
Stockholders are the owners of for-proļ¬t corporations, and as such they
have certain rights and privileges. The most important of these rights and
359
privileges are discussed in this section.
360 Healthcare Finance

Claim on Residual Earnings
The reason why most people buy common stock is to gain the right to a
proportionate share of the residual earnings of the ļ¬rm. A ļ¬rmā™s net income,
which is the residual earnings after all expenses have been paid, belongs to the
ļ¬rmā™s stockholders. Some portion of net income may be paid out in dividends,
in which case stockholders receive quarterly cash payments.2
The portion of net income that is retained within the business will be
invested in new assets, which presumably will increase the ļ¬rmā™s earnings,
and hence dividends, over time. An increasing dividend stream means that the
stock will be more valuable in the future than it is today because dividends will
be higherā”for example, in ļ¬ve yearsā”than they are now. Thus, stockholders
typically expect to be able to sell their stock at some time in the future at a
higher price than they paid for it and hence realize a capital gain. To illustrate
the payment of dividends, consider Table 12.1, which lists the annual per
share dividend payment and earnings, as well as the average annual stock
price, for Big Sky Healthcare from 1994 through 2004. Over the ten growth
periods, Big Skyā™s dividend grew by 275 percent, or at an average annual rate
of 14.1 percent. At the same time, the ļ¬rmā™s stock price grew by 247 percent,
producing an average annual rate of return of 13.2 percent.
Although Big Skyā™s dividend growth averaged 14.1 percent annually
over the period, it was not a constant 14.1 percent each year. Firms often hold
the dividend constant for several years to allow earnings to climb to a point
where it is clear that a higher dividend payment is warranted. For example,
Big Sky kept its dividend at \$0.23 a share from 1995 through 1997, while
earnings per share were ļ¬‚at at about \$0.55.
In general, managers are very reluctant to reduce dividends because
investors interpret lower dividends as a signal that management forecasts poor
earnings ahead. Thus, when Big Sky saw its earnings per share temporarily
tumble from \$1.25 in 2000 to \$0.45 in 2001, it maintained its \$0.58 per share

TABLE 12.1
Annual per Share Annual per Share Average Annual
Big Sky
Year Dividend Earnings Stock Price
Healthcare:
Selected
1994 \$0.20 \$0.48 \$ 7.70
Financial Data
1995 0.23 0.55 10.95
1996 0.23 0.52 11.00
1997 0.23 0.58 10.40
1998 0.48 0.85 15.30
1999 0.52 1.10 18.70
2000 0.58 1.25 20.60
2001 0.58 0.45 19.50
2002 0.65 1.35 23.20
2003 0.70 1.50 24.40
2004 0.75 1.55 26.70
361
Chapter 12: Equity Financing

dividend. Big Sky was able to pay a cash dividend that exceeded earnings in
2001 because the ļ¬rmā™s cash ļ¬‚ow, which generally exceeds net income, easily
supported the dividend.3 When earnings picked up again in 2002, Big Sky
increased its dividend to \$0.65.
Over the entire period, Big Sky has proved to be a good investment for
stockholders. For example, assume that the stock was purchased for \$7.70 in
1994, a \$0.20 dividend payment was paid for the stock, and then the stock
was sold one year later for \$10.95. For simplicity, assume that the dividend
payment, rather than occurring quarterly, was paid at the end of the one-
year holding period. Thus, \$7.70 was paid for the stock, and one year later
\$10.95 + \$0.20 = \$11.15 was received, for a rate of return of 44.8 percent.
However, investors who bought Big Skyā™s stock in 1996 or 2000 and then
sold it one year later would have had a capital loss rather than a capital gain
on the sale, even though they would have received quarterly dividends over
each one-year holding period. We will discuss stock valuation in more detail
later in the chapter.

Control of the Firm
Common stockholders have the right to elect the ļ¬rmā™s directors, who in
turn elect the ofļ¬cers who will manage the business. In small ļ¬rms, the major
stockholder often assumes the positions of chief executive ofļ¬cer (CEO) and
chairman of the board of directors. In large, publicly owned ļ¬rms, managers
typically own some stock, but their personal holdings are insufļ¬cient to allow
them to exercise voting control. Thus, stockholders can remove the man-
agement of most publicly owned ļ¬rms if they decide a management team is
ineffective.
Various state and federal laws stipulate how stockholder control is to be
exercised. First, corporations must hold an election of directors periodically,
usually once a year, with the vote taken at the annual meeting. Frequently, one
third of the directors are elected each year for a three-year term. Each share
of stock has one vote; thus, the owner of 1,000 shares has 1,000 votes. Stock-
holders can appear at the annual meeting and vote in person, but typically
they transfer their right to vote to a second party by means of a proxy. Man-
agement always solicits stockholdersā™ proxies and usually gets them. However,
if common stockholders are dissatisļ¬ed with current management, an outside
group may solicit the proxies in an effort to overthrow management and take
control of the business. Such a bid for control is known as a proxy ļ¬ght.
A hostile takeover occurs when a control change takes place without ap-
proval by the managers of the ļ¬rm being bought. Managers who do not have
majority control are very concerned about hostile takeovers. One of the most
common tactics to thwart a hostile takeover is to place a poison pill provision
in the corporate charter. A poison pill typically permits stockholders of the
ļ¬rm that is taken over to buy shares of the ļ¬rm that instituted the takeover
at a greatly reduced price. Obviously, shareholders of the acquiring ļ¬rm do
362 Healthcare Finance

not want an outside group to get bargain-priced stock, so such provisions
effectively stop hostile takeovers. Although poison pill provisions of this type
might appear to be illegal, they have withheld all court challenges. The ulti-
mate effect of poison pills is to force acquiring ļ¬rms to get the approval of the
managers of the other ļ¬rm prior to the takeover. Although the stated reason
for poison pills is to protect shareholders against a hostile takeover at a price
that is too low, many people believe that they protect managers more than
stockholders.

The Preemptive Right
Common stockholders sometimes have the right, called the preemptive right,
to purchase any new shares sold by the ļ¬rm. The purpose of the preemptive
right is twofold. First, it protects the present stockholdersā™ power of control.
If it were not for this safeguard, the management of a corporation under
criticism from stockholders could secure its position by issuing a large number
of additional shares and purchasing the shares themselves or selling them to
a friendly party. Management would thereby gain control of the corporation
and frustrate current stockholders.
The second, and more important, purpose for the preemptive right is
that it protects stockholders against dilution of value should new shares be
issued at less than the current market price. For example, suppose HealthOne
HMO has 1,000 shares of common stock outstanding, each with a price
of \$100, making a total market value of \$100,000. If an additional 1,000
shares were sold to friends and relatives of management at \$50 a share, or for
\$50,000, this would presumably raise the total market value of HealthOneā™s
stock to \$150,000. When the new market value is divided by the new number
of shares outstanding, a share price of \$75 is obtained. HealthOneā™s old
stockholders thus lose \$25 per share, and the new stockholders have an instant
proļ¬t of \$25 per share. As demonstrated by this example, selling common
stock at a price below the current market price dilutes value and transfers
wealth from the present stockholders to those who purchase the new shares.
The preemptive right, which gives current stockholders the ļ¬rst opportunity
to buy any new shares, protects them against such dilution of value.

Self-Test 1. In what forms do common stock investors receive returns?
Questions 2. How do common stockholders exercise their right of control?
3. What is the preemptive right and what is its purpose?

Types of Common Stock
Although most for-proļ¬t corporations issue only one type of common stock,
in some instances several types of stock are used to meet the special needs of
the company. Generally, when special classiļ¬cations of stock are used, one type
363
Chapter 12: Equity Financing

is designated Class A, another Class B, and so on. For this reason, such stock
is called classiļ¬ed stock.
Small, new companies that seek to obtain funds from outside sources
frequently use classiļ¬ed stock. For example, when Genetic Research, Inc.,
went public in 2001, its Class A stock was sold to the public and paid a
dividend but carried no voting rights for ļ¬ve years. Its Class B stock was
retained by the organizers of the company and carried full voting rights for
ļ¬ve years, but dividends could not be paid on the Class B stock until the
company had established its earning power by building up retained earnings to
a designated level. The ļ¬rmā™s use of classiļ¬ed stock allowed the public to take
a position in a conservatively ļ¬nanced growth company without sacriļ¬cing
income, while the founders retained absolute control during the crucial early
stages of the ļ¬rmā™s development. At the same time, outside investors were
protected against excessive withdrawals of funds by the original owners. As is
often the case in such situations, the Class B stock was also called foundersā™
shares.
Class A, Class B, and so on, have no standard meanings. Most ļ¬rms
have no classiļ¬ed shares, but a ļ¬rm that does could designate its Class B shares
as foundersā™ shares and its Class A shares as those sold to the public. Other
ļ¬rms could use the A and B designations for entirely different purposes.

Self-Test
1. What is meant by the term classiļ¬ed stock?
Questions
2. Give one reason for using classiļ¬ed stock.

Procedures for Selling New Common Stock
For-proļ¬t corporations can sell new common stock in a variety of ways. In this
section, we describe the most common methods.

Rights Offerings
As discussed previously, common stockholders often have the preemptive right
to purchase any additional shares sold by the ļ¬rm. If the preemptive right is
contained in a particular ļ¬rmā™s charter, the company must offer any newly is-
sued common stock to existing stockholders. If the charter does not prescribe
a preemptive right, the ļ¬rm can choose to sell to its existing stockholders or
to the public at large. If it sells its newly issued shares to the existing stock-
holders, the stock sale is called a rights offering. Each existing stockholder is
issued an option giving the holder the right to buy a certain number of the new
shares, typically at a price below the existing market price. The precise terms
of the option are listed on a certiļ¬cate called a stock purchase right, or simply
a right. If the stockholder does not wish to purchase any additional shares in
the company, he or she can sell the rights to another person who does want
364 Healthcare Finance

Public Offerings
If the preemptive right exists in a companyā™s charter, it must sell new stock
through a rights offering. If the preemptive right does not exist, the company
may choose to offer the new shares to the general public through a public
offering. Procedures for public offerings are discussed in detail in a later
section.

Private Placements
In a private placement, securities are sold to one or a few investors, generally
institutional investors. As discussed in Chapter 11, private placements are most
common with bonds, but they also occur with stock. The primary advantages
of private placements are lower administrative costs and greater speed because
the shares do not have to go through the SEC registration process.
The primary disadvantage of a private placement is that the securities,
because they are unregistered, must be sold to a large, sophisticated investorā”
usually an insurance company, mutual fund, or pension fund. Furthermore, in
the event that the original purchaser wants to sell privately placed securities,
they must be sold to a similar investor. However, the SEC currently allows
any institution with a portfolio of \$100 million or more to buy and sell private
placement securities. Because thousands of institutions have assets that exceed
this limit, there is a large market for the resale of private placements, and hence
they are becoming more popular with issuers.

Employee Stock Purchase Plans
Many companies have plans that allow employees to purchase stock of the
employing ļ¬rm on favorable terms. Such plans are generically referred to as
employee stock purchase plans. Under executive incentive stock option plans, key
managers are given options to purchase stock at a ļ¬xed priced. These managers
generally have a direct, material inļ¬‚uence on the companyā™s fortunes, so if they
perform well, the stock price will go up and the options will become valuable.
Also, many companies have stock purchase plans for lower-level employ-
ees. For example, Texas HealthPlans, Inc., a regional investor-owned HMO,
permits employees who are not participants in its stock option plan to allocate
up to 10 percent of their salaries to its stock purchase plan. The funds are
then used to buy newly issued shares at 85 percent of the market price on
the purchase date. The companyā™s contribution, the 15 percent discount, is
not vested in an employee until ļ¬ve years after the purchase date. Thus, the
employee cannot realize the beneļ¬t of the companyā™s contribution without
working an additional ļ¬ve years. This type of plan is designed both to improve
employee performance and to reduce employee turnover.

Dividend Reinvestment Plans
Many large companies have dividend reinvestment plans (DRIPs), whereby
stockholders can automatically reinvest their dividends in the stock of the
365
Chapter 12: Equity Financing

paying corporation. There are two basic types of DRIPs: plans that involve
only old stock that is already outstanding and plans that involve newly issued
stock. In either case, the stockholder must pay income taxes on the dollar
amount of the dividends, even though stock, rather than cash, is received.
Under both types of DRIP, stockholders must choose between contin-
uing to receive cash dividends or using the cash dividends to buy more stock
in the corporation. Under the old stock type of plan, a bank, acting as a trustee,
takes the total funds available for reinvestment from each quarterly dividend,
purchases the corporationā™s stock on the open market, and allocates the shares
purchased to the participating stockholders on a pro rata basis. The brokerage
costs of buying the shares are low because of volume purchases, so these plans
beneļ¬t small stockholders who do not need cash for current consumption.
The new stock type of DRIP provides for dividends to be invested in
newly issued stock; hence, these plans raise new capital for the ļ¬rm. No fees
are charged to participating stockholders, and some companies offer the new
stock at a discount of 3 to 5 percent below the prevailing market price. The
companies absorb these costs as a trade-off against the issuance costs that
would be incurred if the stock were sold through investment bankers rather
than through the DRIP.

Direct Purchase Plans
In recent years, many companies have established direct purchase plans, which
allow individual investors to purchase stock directly from the company. Many
of these plans grew out of DRIPs, which were expanded to allow participants
to purchase shares in excess of the dividend amount. In direct purchase plans,
investors usually pay little or no brokerage fees, and many plans offer conve-
nient features such as fractional share purchases, automatic purchases by bank
debit, and quarterly statements. Although employee purchase plans, DRIPS,
and direct purchase plans are an excellent way for employees and individual
investors to purchase stock, they typically do not raise large sums of new capital
for the ļ¬rm, so other methods must be used when equity needs are great.

Self-Test
1. What is a rights offering?
Questions
2. What is a private placement, and what are its primary advantages over a
public offering?
3. Brieļ¬‚y, what are employee stock purchase plans?
4. What is a dividend reinvestment plan?
5. What is a direct purchase plan?

The Market for Common Stock
Some for-proļ¬t corporations are so small that their common stock is not
actively tradedā”it is owned by only a few people, usually the companiesā™
366 Healthcare Finance

managers. Such companies are said to be privately held, or closely held, and
the stock is said to be closely held stock.
The stocks of some publicly owned ļ¬rms are not listed on any exchange;
they trade in the over-the-counter (OTC) market. This market is composed
of brokers and dealers who belong to a trade group called the National
Association of Securities Dealers (NASD), which licenses brokers and oversees
the OTC market is known as the NASD Automated Quotation System, or
NASDAQ. Thus, over-the-counter transactions are listed in the Wall Street
Journal and other publications under the title NASDAQ. Stocks traded on
the OTC market (and their companies) are said to be unlisted.
Most larger publicly owned companies apply for listing on an exchange.
These companies and their stocks are said to be listed. As a general rule, com-
panies are ļ¬rst listed on a regional exchange, such as the Paciļ¬c or Midwest ;
then they move up to the American (AMEX ); and ļ¬nally, if they grow large
enough, to the āBig Boardāā”the New York Stock Exchange (NYSE). For ex-
ample, American Healthcare Management, a company based in King of Prus-
sia, Pennsylvania that owns or manages 16 hospitals in nine states, recently
listed on the NYSE. The stock had previously traded on the AMEX, but the
ļ¬rmā™s managers believed that listing on the NYSE would increase the trading
of its shares and make the company more visible to the investment community,
which presumably would have a positive impact on stock price. Many more
stocks are traded in the OTC market than on the NYSE, and daily trading
volume in the OTC market exceeds that of the NYSE.
Institutional investors such as pension funds, insurance companies, and
mutual funds own about 60 percent of all common stocks. However, the in-
stitutions buy and sell relatively actively, so they account for about 75 percent
of all transactions. Thus, the institutions have a heavy inļ¬‚uence on the prices
of individual stocks.
Stock market transactions can be classiļ¬ed into three distinct categories:

1. The new issue market. A small ļ¬rm typically is owned by its management
and a handful of private investors. At some point, if the ļ¬rm is to grow
further, its stock must be sold to the general public, which is deļ¬ned
as going public. The market for stock that is in the process of going
public is often called the new issue market, and the issue is called an
initial public offering (IPO). To illustrate, Community Health Systems, a
Tennessee-based hospital operator, recently raised over \$200 million in
an IPO by selling about 16 million shares at \$13 per share. At the time,
insiders held about 3 million shares, so the IPO left the company with
about 19 million shares outstanding. The share price climbed to \$35 by
the end of the year, giving the new public investors, as well as the original
insiders, cause to celebrate.
2. The primary market. Paciļ¬c Eldercare, which operates 79 nursing
367
Chapter 12: Equity Financing

homes in ten states, recently sold 3.1 million shares of new common
stock, thereby raising \$31.2 million of new equity ļ¬nancing. Because the
shares sold were newly created, the issue was deļ¬ned as a primary market
offering, but because the ļ¬rm was already publicly held, the offering was
not an IPO. Corporations prefer to obtain equity by retaining earnings
because of issuance costs and the tendency for a new stock issue to
depress stock prices. Still, if a ļ¬rm requires more equity funds than can be
generated from retained earnings, a stock sale may be required.
3. The secondary market. If the owner of 100 shares of HCA sells his
or her stock, the trade is said to have occurred in the secondary market.
The market for shares that have already been issued, and hence are
outstanding, is deļ¬ned as the secondary market. About 4.5 million shares
of HCA are bought and sold on the NYSE daily, but the company does
not receive a dime from these transactions.

Self-Test
1. What is an initial public offering (IPO)?
Questions
2. What is meant when a stock is listed?
3. What are the differences between HCA selling shares in the primary
market versus its shares being sold in the secondary market?

Regulation of Securities Markets
Sales of securities are regulated by the Securities and Exchange Commission
(SEC) and, to a lesser extent, by the Federal Reserve Board and each of the
50 states. Here are the primary elements of SEC regulation:

ā¢ The SEC has jurisdiction over all interstate offerings of new securities to
the public in amounts of \$1.5 million or more.
ā¢ Newly issued securities must be registered with the SEC at least 20 days
before they are offered to the public. The registration statement provides
the SEC with ļ¬nancial, legal, and technical information about the
company, and the prospectus summarizes this information for investors.
SEC lawyers and accountants analyze both the registration statement and
will delay or stop the public offering.
ā¢ After the registration becomes effective, new securities may be offered, but
any sales solicitation must be accompanied by the prospectus. Preliminary,
or red herring, prospectuses may be distributed to potential buyers during
the 20-day waiting period, but no sales may occur during this time. The
red herring prospectus contains all the key information that will appear in
the ļ¬nal prospectus except the price, which is generally set after the market
closes the day before the new securities are actually offered to the public.
368 Healthcare Finance

ā¢ If the registration statement or prospectus contains misrepresentations or
omissions of material facts, any purchaser who suffers a loss may sue for
damages. Severe penalties may be imposed on the issuer or its ofļ¬cers,
directors, accountants, engineers, appraisers, underwriters, and all others
who participated in the preparation of the registration statement or
prospectus.
ā¢ The SEC also regulates all national stock exchanges. Companies whose
securities are listed on an exchange must ļ¬le annual reports with both the
SEC and the exchange.
ā¢ The SEC has control over corporate insiders. Ofļ¬cers, directors, and major
stockholders must ļ¬le monthly reports of changes in their holdings of the
stock of the corporation.
ā¢ The SEC has the power to prohibit manipulation by such devices as pools
(i.e., large amounts of money used to buy or sell stocks to artiļ¬cially affect
prices) or wash sales (i.e., sales between members of the same group to
record artiļ¬cial transaction prices).
ā¢ The SEC has control over the form of the proxy and the way the company

Control over the use of credit to buy securities (primarily common
stock) is exercised by the Federal Reserve Board through margin requirements,
which specify the maximum percentage of the purchase price that can be
ļ¬nanced by brokerage borrowings. The current margin requirement is 50
percent, so stock investors can borrow up to half of the cost of a stock purchase
from his or her broker. If the stock price of a stock bought on margin falls,
then the margin money (50 percent of the original value) becomes more than
half the current value, and the investor is forced to put up additional personal
funds. Such a demand for more personal money is known as a margin call. The
amount of additional funds required depends on the maintenance margin,
which is set by the broker supplying the loan. When a large proportion of
trades are on margin and the stock market begins a retreat, the volume of
margin calls can be substantial. Because most investors who buy on margin
do not have a large reserve of personal funds, they are forced to sell some
stock to meet margin calls, which, in turn, can accelerate a market decline.
States also exercise control over the issuance of new securities within
their boundaries. Such control is usually supervised by a corporation commis-
sioner or someone with a similar title. State laws that relate to security sales
are called blue sky laws because they were put into effect to keep unscrupu-
lous promoters from selling securities that offered the āblue skyā (something
wonderful) but that actually had no assets or earnings to back up the promises.
The securities industry itself realizes the importance of stable markets,
sound brokerage ļ¬rms, and the absence of price manipulation. Therefore, the
various exchanges, as well as other industry trade groups, work closely with the
SEC to monitor transactions and to maintain the integrity and credibility of
369
Chapter 12: Equity Financing

the system. These industry groups also cooperate with regulatory authorities
to set net worth and other standards for securities ļ¬rms, to develop insurance
programs that protect the customers of brokerage houses, and the like.
In general, government regulation of securities trading, as well as in-
dustry self-regulation, is designed to ensure that investors receive information
that is as accurate as possible, that no one artiļ¬cially manipulates the market
price of a given security, and that corporate insiders do not take advantage of
their position to proļ¬t in their companiesā™ securities at the expense of oth-
ers. Neither the SEC, nor state regulators, nor the industry itself can prevent
investors from making foolish decisions, but they can and do help investors
obtain the best information possible, which is the ļ¬rst step in making sound
investment decisions.

Self-Test
1. What is the purpose of securities markets regulation?
Questions
2. What agencies and groups are involved in such regulation?
3. What is a prospectus?
4. What is a margin requirement?
5. What are āblue skyā laws?

The Investment Banking Process
Investment banks are the companies, such as Citigroup, J.P. Morgan Securities,
and Merrill Lynch, that help businesses sell securities to the public. When new
securities will be sold to the public, the ļ¬rst step is to select an investment
banker. This can be a difļ¬cult decision for a ļ¬rm that is going public. However,
an older ļ¬rm that has already ābeen to marketā will have an established
relationship with an investment banker. Changing bankers is easy, though,
if the ļ¬rm is dissatisļ¬ed.
The procedures followed in issuing new securities are collectively
known as the investment banking process. Generally, the following key deci-
sions regarding the issuance of new securities are made jointly by the issuing
companyā™s managers and the investment bankers that will handle the deal:

ā¢ Dollars to be raised. How much new capital is needed?
ā¢ Type of securities used. Should common stock, bonds, another security,
or a combination of securities be used? Furthermore, if common stock is
to be issued, should it be done as a rights offering, by a direct sale to the
general public, or by a private placement?
ā¢ Contractual basis of issue. If an investment banker is used, will the
banker work on a best efforts basis or will the banker underwrite the issue?
In a best efforts sale, the banker guarantees neither the price nor the sale
of the securities, only that it will put forth its best efforts to sell the issue.
On an underwritten issue, the company does get a guarantee because the
370 Healthcare Finance

banker agrees to buy the entire issue and then resell the securities to its
customers. Bankers bear signiļ¬cant risk in underwritten offerings because
the banker must bear the loss if the price of the security falls between the
time the security is purchased from the issuer and the time of resale to the
public.
ā¢ Bankerā™s compensation and other expenses. The investment bankerā™s
compensation (if one is used) must be negotiated. Also, the ļ¬rm must
estimate the other issuance expenses it will incur in connection with the
issueā”lawyersā™ fees, accountantsā™ costs, printing and engraving, and so on.
In an underwritten issue, the banker will buy the issue from the company
at a discount below the price at which the securities are to be offered to
the public, with this spread being set to cover the bankerā™s costs and to
provide a proļ¬t. In a best efforts sale, fees to the investment banker are
normally set as some percentage of the dollar volume sold. Issuance costs
as a percentage of the proceeds are higher for stocks than for bonds, and
costs are higher for small than for large issues. The relationship between
size of issue and issuance cost primarily is a result of the existence of ļ¬xed
costsā”certain costs must be incurred regardless of the size of the issue, so
the percentage cost is quite high for small issues. To illustrate, issuance
costs for a \$5 million bond issue are about 5 percent, while the costs drop
to about 1 percent for issues over \$50 million. For a stock issue, the costs
are about 12 percent and 4 percent, respectively.
ā¢ Setting the offering price. Usually, the offering price will be based on the
existing market price of the stock or the yield to maturity on outstanding
bonds. On initial public offerings, however, pricing decisions are much
more difļ¬cult because there is no existing market price for guidance. The
investment banker will have an easier job if the issue is priced relatively
low, but the issuer of the securities naturally wants as high a price as
possible. Conļ¬‚ict of interest on price therefore arises between the
investment banker and the issuer. If the issuer is ļ¬nancially sophisticated
and makes comparisons with similar security issues, the investment banker
will be forced to price the new security close to its true value.

After the company and its investment banker have decided how much
money to raise, the types of securities to issue, and the basis for pricing the
issue, they will prepare and ļ¬le a registration statement and a prospectus (if
needed). The ļ¬nal price of the stock or the interest rate on a bond issue is set
at the close of business the day the issue clears the SEC, and the securities are
offered to the public the following day.
Investors are required to pay for securities within ten days, and the
investment banker must pay the issuing ļ¬rm within four days of the ofļ¬cial
commencement of the offering. Typically, the banker sells the securities within
a day or two after the offering begins. However, on occasion, the banker
miscalculates, sets the offering price too high, and thus is unable to move the
371
Chapter 12: Equity Financing

issue. At other times, the market declines during the offering period, forcing
the banker to reduce the price of the stock or bonds. In either instance, on
an underwritten offering, the ļ¬rm receives the agreed-upon dollar amount,
so the banker must absorb any losses incurred.
Because they are exposed to large potential losses, investment bankers
typically do not handle the purchase and distribution of issues single-handedly
unless the issue is a very small one. If the sum of money involved is large,
investment bankers form underwriting syndicates in an effort to minimize the
risk that each banker carries. The banking house that sets up the deal is called
In addition to the underwriting syndicate, on larger offerings even
more investment bankers are included in a selling group, which handles the
distribution of securities to individual investors. The selling group includes
all members of the underwriting syndicate, plus additional dealers who take
relatively small percentages of the total issue from members of the underwrit-
ing syndicate. Thus, the underwriters act as wholesalers, while members of the
selling group act as retailers. The number of investment banks in a selling
group depends partly on the size of the issue but also on the number and
types of buyers. For example, the selling group that handled a recent \$92
million municipal bond issue for Adventist Health System/Sunbelt consisted
of three members, while the one that sold \$1 billion in B-rated junk bonds
for National Medical Enterprises consisted of eight members.5

Self-Test
1. What types of decisions must the issuer and its investment banker make?
Questions
2. What is the difference between an underwritten and a best efforts issue?
3. Are there any conļ¬‚icts that might arise between the issuer and the
investment banker when setting the offering price on a securities issue?

Investor-owned businesses have two sources of equity ļ¬nancing: retained
earnings and new stock sales. Not-for-proļ¬t businesses can and do retain earn-
ings, but they do not have access to the equity marketsā”that is, they cannot
sell common stock to raise equity capital.6 Not-for-proļ¬t ļ¬rms can, however,
raise equity capital through government grants and charitable contributions.
Federal, state, and local governments are concerned about the provi-
sion of healthcare services to the general population. Therefore, these public
entities often make grants to not-for-proļ¬t providers to help offset the costs
of services rendered to patients who cannot pay for those services. Sometimes
these grants are nonspeciļ¬c, but often they are to provide speciļ¬c services such
as neonatal intensive care to needy infants.
As for charitable contributions, individuals, as well as companies, are
motivated to contribute to not-for-proļ¬t health services organizations for a
372 Healthcare Finance

variety of reasons, including concern for the well-being of others, the recogni-
tion that often accompanies large contributions, and tax deductibility. Because
only contributions to not-for-proļ¬t ļ¬rms are tax deductible, this source of
funding is, for all practical purposes, not available to investor-owned health
services organizations. Although charitable contributions are not a substitute
for proļ¬t retentions, charitable contributions can be a signiļ¬cant source of
fund capital.
Most not-for-proļ¬t hospitals received their initial, start-up equity cap-
ital from religious, educational, or governmental entities, and today some
hospitals continue to receive funding from these sources. However, since the
1970s, these sources have provided a much smaller proportion of hospital
funding, forcing not-for-proļ¬t hospitals to rely more on proļ¬ts and outside
contributions. Additionally, state and local governments, which are also facing
signiļ¬cant ļ¬nancial pressures, are ļ¬nding it more and more difļ¬cult to fund
grants to healthcare providers.
Finally, as discussed in Chapter 2, a growing trend among legislative
bodies and tax authorities is to force not-for-proļ¬t hospitals to āearnā their
favorable tax treatment by providing a certain amount of charity care. Even
more severe, some cities have pressured not-for-proļ¬t hospitals to make āvol-
untaryā payments to the city to make up for lost property tax revenue. These
trends tend to reduce the ability of not-for-proļ¬t health services organizations
to raise equity capital by grants and contributions; hence, the result is increased
reliance on making money the old fashioned wayā”by earning it.
On the surface, investor-owned ļ¬rms may appear to have a signiļ¬cant
advantage in raising equity capital. In theory, new common stock can be issued
at any time and in any reasonable amount. Conversely, charitable contribu-
tions are much less certain. The planning, solicitation, and collection periods
can take years, and pledges are not always collected. Therefore, charitable con-
tributions that were counted on may not materialize. Also, the proceeds of
new stock sales may be used for any purpose, but charitable contributions of-
ten are restricted, in which case they can be used only for a designated purpose.
In reality, however, managers of investor-owned ļ¬rms do not have
complete freedom to raise capital by selling new common stock. First, the
issuance expenses associated with a new common stock issue are not trivial.
Second, if market conditions are poor and the stock is selling at a low price, a
new stock issue can dilute the value of existing shares and hence be harmful to
current stockholders. Finally, new stock issues are often viewed by investors as
a signal that the ļ¬rmā™s stock is overvalued, and hence new issues often drive
the stock price lower.
For all these reasons, managers of investor-owned ļ¬rms would rather
not issue new common stock. The key point here is that yes, for-proļ¬t health
services organizations do have greater access to equity capital than do not-for-
373
Chapter 12: Equity Financing

be as great an advantage as it initially appears. The greatest advantage is for
young, growing businesses that need a great deal of new capital. More mature
companies have much less ļ¬‚exibility in raising new equity capital.

Self-Test
1. What are the sources of equity (i.e., fund capital) to not-for-proļ¬t
Questions
ļ¬rms?
2. Are not-for-proļ¬t ļ¬rms at a disadvantage when it comes to raising

Common Stock Valuation
For many reasons, the valuation of common stocks is a difļ¬cult and perplexing
process. To begin, the type of valuation model used depends on the charac-
teristics of the ļ¬rm being valued. In general, there are three distinct types of

1. Start-up businesses. A business in its infancy generally pays no dividends
because all earnings must be reinvested in the business to fund growth.
To make matters worse, start-up ļ¬rms often take years to make a proļ¬t,
so there is no track record of positive earnings to use as a basis for a
cash ļ¬‚ow forecast. Under such conditions, the general valuation model
cannot be applied because the value of such a business stems more from
potential opportunities than from existing product or service lines. Even
if most of the opportunities do not materialize, one or two could turn
into blockbusters and hence create a highly successful ļ¬rm. With such
ļ¬rms, option pricing techniques, which are beyond the scope of this book,
can be used, at least in theory, to value the stock. In reality, valuations on
these ļ¬rms are not much more than a shot in the dark, and hence stock
prices are based mostly on qualitative factors, including emotions. The
end result is that stock prices of such businesses usually are highly volatile.
2. Young businesses. As a ļ¬rm passes through its initial start-up phase,
it often reaches a point where it has more or less predictable positive
earnings but still requires reinvestment of these earnings, so no dividends
are paid. In such cases, it is possible to value the entire ļ¬rm, as well as the
stock of the ļ¬rm, on the basis of the expected earnings stream. In such a
valuation, the expected earnings stream is discounted, or capitalized, to
ļ¬nd the current value of the ļ¬rm. Then, the value of the debt is stripped
off to estimate the value of the common stock.
3. Mature businesses. Mature ļ¬rms generally pay a relatively predictable
dividend, and hence the future dividend stream can be forecasted with
reasonable conļ¬dence. In such cases, the common stock can be valued
374 Healthcare Finance

on the basis of the present value of the expected dividend stream. We
illustrate this approach in the following sections.

The Dividend Valuation Model
Common stocks with a predictable dividend stream can be valued using the
general valuation model applied to the expected dividend stream. This ap-
proach is called the dividend valuation model.

Basic Here are some deļ¬nitions that will be used in the illustration:
Deļ¬nitions
ā¢ E(Dt) = Dividend the stockholder expects to receive at the end of Year t.
D0 is the most recent dividend, which has already been paid and is known
with certainty; E(D1) is the ļ¬rst dividend expected and for valuation
purposes is assumed to be paid at the end of one year; E(D2) is the
dividend expected at the end of two years; and so forth. E(D1) represents
the ļ¬rst cash ļ¬‚ow a new purchaser of the stock will receive. D0, the
dividend that has just been paid, is known with certainty, but all future
dividends are expected values, so the estimate of any E(Dt) may differ
among investors.7
ā¢ P0 = Actual market price of the stock today.
ā¢ E(Pt) = Expected price of the stock at the end of each Year t. E(P0) is the
value of the stock today, as seen by a particular investor based on his or
her estimate of the stockā™s expected dividend stream and riskiness; E(P1) is
the price expected at the end of one year; and so on. Thus, whereas P0, the
current stock price, is ļ¬xed and is identical for all investors, E(P0) will
differ among investors depending on each investorā™s assessment of the
stockā™s riskiness and dividend stream. E(P0), each investorā™s estimate of the
value today, could be above or below P0, but an investor would buy the
stock only if his or her estimate of E(P0) were equal to or greater than P0.
ā¢ E(gt) = Expected growth rate in dividends in each future Year t. Different
investors may use different E(gt)s to evaluate a ļ¬rmā™s stock. In reality,
E(gt) is normally different for each Year t. However, the valuation process
will be simpliļ¬ed by assuming that E(gt) is constant across time.
ā¢ R(Re) = Required rate of return on the stock, considering both its
riskiness and the returns available on other investments. Again, we use the
subscript āeā (for equity) to identify the return as a stock return.
ā¢ E(Re) = Expected rate of return on the stock. E(Re) could be above or
below R(Re), but an investor would buy the stock only if his or her E(Re)
were equal to or greater than R(Re). Note that E(Re) is an expectation. A
return of E(Re) = 15% may be expected if HCA stock were purchased
today. If either conditions in the market or prospects at HCA take a turn
for the worse, however, the realized return may be much lower than
expected, perhaps even negative.
375
Chapter 12: Equity Financing

ā¢ E(D1) / P0 = Expected dividend yield on a stock during the ļ¬rst year. If a
stock is expected to pay a dividend of \$1 during the next 12 months, and
if its current price is \$10, then its expected dividend yield is \$1 / \$10 =
0.10 = 10%.
ā¢ [E(P1) ā’ P0] / P0 = Expected capital gains yield on the stock during the
ļ¬rst year. If the stock sells for \$10 today, and if it is expected to rise to
\$10.50 at the end of the year, then the expected capital gain is E(P1) ā’ P0
= \$10.50 ā’ \$10.00 = \$0.50; and the expected capital gains yield is
[E(P1) ā’ P0] / P0 = \$0.50 / \$10 = 0.050 = 5.0%.

Expected
At ļ¬rst blush, it might appear that the value of a stock is inļ¬‚uenced by both
Dividends as
the dividend stream and expected capital gains. However, the value of capital
the Sole Basis
gains is embedded in the dividend stream. To see this, consider an investor
for Stock
who buys a stock with the intention of holding it in his or her family forever.
Values
In this situation, all the investor and his or her heirs will receive is a stream of
dividends, and the value of the stock today is calculated as the present value
of an inļ¬nite stream of dividends.
Now consider the more typical case in which an investor expects to
hold the stock for a ļ¬nite period and then sell it. What would be the value
of the stock in this case? The value of the stock is again the present value of
the expected dividend stream. To see this, recognize that for any individual
investor, expected cash ļ¬‚ows consist of expected dividends plus the expected
price of the stock when it is sold. However, the sale price received by the
current investor will depend on the dividends some future investor expects
to receive. Therefore, for all present and future investors in total, expected
cash ļ¬‚ows must be based on expected future dividends. To put it another
way, unless a business is liquidated or sold to another concern, the cash
ļ¬‚ows it provides to its stockholders consist only of a stream of dividends;
therefore, the value of a share of its stock must be the present value of that
expected dividend stream. Occasionally, stock shares could have additional
value, such as the value of a controlling interest when an investor buys 51
percent of a companyā™s outstanding stock or the added value brought about
by a takeover bid. However, in most situations, the sole value inherent in stock
ownership stems from the dividends expected to be paid by the company to
its shareholders.
Investors periodically lose sight of the long-run nature of stocks as
investments and forget that in order to sell a stock at a proļ¬t, one must ļ¬nd a
buyer who will pay the higher price. Suppose that a stockā™s value is analyzed
on the basis of expected future dividends and the conclusion is that the stockā™s
market price exceeded a reasonable value. If an investor buys the stock anyway,
he or she would be following the ābigger foolā theory of investment: The
investor may be a fool to buy the stock at its excessive price, but he or she
believes that when ready to sell an even bigger fool can be found.
376 Healthcare Finance

Constant Growth Stock Valuation
If the projected stream of dividends follows a systematic pattern, it is possi-
ble to develop a simpliļ¬ed (i.e., easier to evaluate) version of the dividend
valuation model. Although the dividends of only a few ļ¬rms actually grow
at a constant rate, the assumption of constant growth is often made because
it makes the forecasting of individual dividends over a long time period un-
necessary. Furthermore, many ļ¬rms come close to meeting constant growth
assumptions. For a constant growth company, the expected dividend growth
rate is constant for all years, so E(g1) = E(g2) = E(g3) and so on, which implies
that E(gt) becomes merely E(g). Under this assumption, the dividend in any
future Year t may be forecast as E(Dt) = D0 Ć— [1 + E(g)]t, where D0 is the
last dividend paid, and hence is known with certainty, and E(g) is the constant
expected rate of growth.
To illustrate, if Minnesota Health Systems, Inc., (MHS) just paid a
dividend of \$1.82 (i.e., D0 = \$1.82), and if investors expect a 10 percent
constant dividend growth rate, the dividend expected in one year will be E(D1)
= \$1.82 Ć— 1.10 = \$2.00; E(D2) will be \$1.82 Ć— (1.10)2 = \$2.20, and the
dividend expected in ļ¬ve years will be E(D5) = D0 Ć— [1 + E(g)]5 = \$1.82 Ć—
(1.10)5 = \$2.93.

The Value of a When E(g) is assumed to be constant, a stock can be valued using the constant
Constant growth model :
Growth Stock
D0 Ć— [1 + E(g)] E(D1 )
E(P0 ) = = ,
R (Re ) ā’ E(g) R (Re ) ā’ E(g)
where R(Re) is the required rate of return on the stock. If D0 = \$1.82, E(g)
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