. 14
( 21)


= 10%, and R(Re) = 16% for MHS, the value of its stock would be $33.33:

$1.82 — 1.10 $2.00
E(P0 ) = = = $33.33.
0.16 ’ 0.10 0.06
Note that a necessary condition for the derivation of the constant
growth model is that the required rate of return on the stock is greater than
its constant dividend growth rate”that is, R(Re) is greater than E(g). If the
constant growth model is used when R(Re) is not greater than E(g), the results
will be meaningless. However, this problem does not affect the model™s use
because no company could grow over the long run at a rate that exceeds
the required rate of return on its stock. Also, note that although the constant
growth model is applied here to stock valuation, it can be used in any situation
in which cash ¬‚ows are growing at a constant rate.
How does an investor determine his or her required rate of return on
a particular stock, R(Re)? One way is to use the Security Market Line (SML)
of the Capital Asset Pricing Model as discussed in Chapter 10. Assume that
MHS™s market beta, as reported by a ¬nancial advisory service, is 1.5. Assume
also that the risk-free interest rate (the rate on long-term Treasury bonds) is 7
Chapter 12: Equity Financing

percent and the required rate of return on the market is 13 percent. According
to the SML, the required rate of return on MHS™s stock is 16.0 percent:

R (RMHS ) = RF + [R (RM ) ’ RF] — b
= 7% + (13% ’ 7%) — 1.5
= 7% + (6% — 1.5)
= 7% + 9% = 16%.

Remember, in the SML, RF is the risk-free rate; R(RM) is the required rate of
return on the market, or the required rate of return on a b = 1.0 stock; and
b is MHS™s market beta.
Growth in dividends occurs primarily as a result of growth in earnings
per share (EPS). Earnings growth, in turn, results from a number of factors,
including the general in¬‚ation rate in the economy and the amount of earnings
the company retains and reinvests. Regarding in¬‚ation, if output in units is
stable, and if both sales prices and input costs increase at the in¬‚ation rate,
EPS also will grow at the in¬‚ation rate. EPS will also grow as a result of
the reinvestment, or plowback, of earnings. If the ¬rm™s earnings are not all
paid out as dividends (i.e., if a fraction of earnings is retained), the dollars of
investment behind each share will rise over time, which should lead to growth
in productive assets and hence growth in earnings and dividends.
When using the constant growth model, the most critical input is
E(g)”the expected constant growth rate in dividends. Investors can make
their own E(g) estimates on the basis of historical dividend growth, but E(g)
estimates are also available from brokerage and investment advisory ¬rms.

Expected Rate
The constant growth model can be rearranged to solve for E(Re), the expected
of Return on a
rate of return. In its normal form, the required rate of return, R(Re), is an
input into the model, but when it is rearranged, the expected rate of return,
Growth Stock
E(Re), is found. This transformation requires that the required rate of return
equal the expected rate of return, or R(Re) = E(Re). This equality holds if the
stock is in equilibrium, a condition that will be discussed later in the chapter.
After solving the constant growth model for E(Re), this expression is obtained:

D0 — [1 + E(g)] E(D1 )
E(Re ) = + E(g) = + E(g).
P0 P0
If an investor buys MHS™s stock today for P0 = $33.33, and expects the
stock to pay a dividend E(D1) = $2.00 one year from now, and for dividends
to grow at a constant rate E(g) = 10% in the future, the expected rate of return
on that stock is 16 percent:

E(RMHS ) = + 10.0% = 6.0% + 10.0% = 16.0%.
378 Healthcare Finance

In this form, E(Re), the expected total return on the stock, consists of an
expected dividend yield, E(D1) / P0 = 6.0%, plus an expected growth rate or
capital gains yield, E(g) = 10%.
Suppose this analysis had been conducted on January 1, 2004, so
P0 = $33.33 is MHS™s January 1, 2004 stock price and E(D1) = $2.00 is
the dividend expected at the end of 2004. What is the value of E(P1), the
company™s stock price expected at the end of 2004 (the beginning of 2005)?
The constant growth model would again be applied, but this time the 2005
dividend, E(D2) = E(D1) — [1 + E(g)] = $2.00 — 1.10 = $2.20, would be
E(D2 ) $2.20
E(P1 ) = = = $36.67.
R (Re ) ’ E(g) 0.06

Notice that E(P1) = $36.67 is 10 percent greater than P0 = $33.33: $33.33
— 1.10 = $36.67. Thus, a capital gain of $36.67 ’ $33.33 = $3.34 would
be expected during 2004, which results in a capital gains yield of 10 percent:

Capital gain $3.34
Capital gains yield = = = 0.100 = 10.0%.
Beginning price $33.33

If the analysis were extended, in each future year the expected capital
gains yield would always equal E(g) because the stock price would grow at
the 10 percent constant dividend growth rate. The expected dividend yield in
2005 (Year 2) could be found as follows:

E(D2 ) $2.20
Dividend yield = = = 0.060 = 6.0%.
E(P1 ) $36.67

The dividend yield for 2006 (Year 3) could also be calculated, and
again it would be 6 percent. Thus, for a constant growth stock, the following
conditions must hold:

• The dividend is expected to grow forever (or at least for a long time) at a
constant rate, E(g).
• The stock price is expected to grow at this same rate.
• The expected dividend yield is a constant.
• The expected capital gains yield is also a constant, and it is equal to E(g).
• The expected total rate of return in any Year t, which is equal to the
expected dividend yield plus the expected capital gains yield (growth rate),
is expressed by this equation: E(Rt) = [E(Dt+ 1) / E(Pt)] + E(g).

The term expected should be clari¬ed”it means expected in a statistical
sense. Thus, if MHS™s dividend growth rate is expected to remain constant at
10 percent, this means that the growth rate in each year can be represented by
a probability distribution with an expected value of 10 percent and not that
Chapter 12: Equity Financing

the growth rate is expected to be exactly 10 percent in each future year. In this
sense, the constant growth assumption is reasonable for many large, mature

Nonconstant Growth Stock Valuation
What happens when a company does not meet the constant growth assump-
tion? For example, what if MHS™s dividend was expected to grow at 30 percent
for three years and then to settle down to a constant growth rate of 10 percent?
Under these nonconstant growth conditions, the value of MHS stock would
be $53.86, which is signi¬cantly higher than the $33.33 value of the stock
assuming 10 percent constant growth. Dividend growth of 30 percent for
three years followed by 10 percent constant growth creates a more valuable
expected dividend stream than straight constant growth at 10 percent. In this
situation, the constant growth model does not apply, so it is necessary to apply
a nonconstant growth model to value the stock. Although nonconstant stock
valuation models are not very complicated, they are beyond the scope of an
introductory book on healthcare ¬nance.8

1. What are three approaches to valuing common stocks?
2. Does the holding period matter when using the dividend valuation
3. Write out and explain the valuation model for a constant growth stock.
4. What are the assumptions of the constant growth model?
5. Show the constant growth model in its expected rate of return form.
6. What are the key features of constant growth regarding dividend yield
and capital gains yield?

Security Market Equilibrium
Investors will want to buy a security if its expected rate of return exceeds its
required rate of return or, put another way, when its value exceeds its current
price. Conversely, investors will want to sell a security when its required rate of
return exceeds its expected rate of return (i.e., when its current price exceeds
its value). When more investors want to buy a security than to sell it, its price
is bid up. When more investors want to sell a security than to buy it, its price
falls. In equilibrium, these two conditions must hold:

• The expected rate of return on a security must equal its required rate of
return. This means that no investor who owns the security believes that its
expected rate of return is less than its required rate of return, and no
investor who does not own the security believes that its expected rate of
return is greater than its required rate of return.
• The market price of a security must equal its value.
380 Healthcare Finance

If these conditions do not hold, trading will occur until they do. Of
course, security prices are not constant. A security™s price can swing wildly
as new information becomes available to the market that changes investors™
expectations concerning the security™s cash ¬‚ow stream or risk or when the
general level of returns (i.e., interest rates) change. However, evidence sug-
gests that securities prices, especially of securities that are actively traded, such
as those issued by the U. S. Treasury or by large ¬rms, adjust rapidly to dis-
equilibrium situations. Thus, most people believe that the bonds of the U. S.
Treasury and the bonds and stocks of major corporations are generally in equi-
librium. The key to the rapid movement of security prices toward equilibrium
is informational ef¬ciency, which is discussed in the next section.

Self-Test 1. What is meant by security market equilibrium?
Questions 2. What securities are most likely to be in equilibrium?

Informational Ef¬ciency
A securities market”say, the market for long-term U. S. Treasury bonds”
is informationally ef¬cient if (1) all information relevant to the values of the
securities traded can be obtained easily and at low cost and (2) the market
contains many buyers and sellers who act rationally on this information. If
these conditions hold, current market prices will have embedded in them all
information of possible relevance; hence, future price movements will be based
solely on new information as it becomes known.
The Ef¬cient Markets Hypothesis (EMH), which has three forms, for-
malizes the theory of informational ef¬ciency:

1. The weak form of the EMH holds that all information contained in past
price movements is fully re¬‚ected in current market prices. Therefore,
information about recent trends in a security™s price is of no value in
choosing which securities will “outperform” other securities.
2. The semistrong form of the EMH holds that current market prices re¬‚ect
all publicly available information. Therefore, it makes no sense to spend
hours and hours analyzing economic data and ¬nancial reports because
whatever information you might ¬nd, good or bad, has already been
absorbed by the market and imbedded in current prices.
3. The strong form of the EMH holds that current market prices re¬‚ect all
relevant information, whether publicly available or privately held. If
this form holds, then even investors with “inside information,” such as
corporate of¬cers, would ¬nd it impossible to earn abnormal returns”that
is, returns in excess of that justi¬ed by the riskiness of the investment.
Chapter 12: Equity Financing

The EMH, in any of its three forms, is merely a hypothesis, so it is not
necessarily true. However, hundreds of empirical tests have been conducted to
try to prove, or disprove, the EMH, and the results are surprisingly consistent.
In general, the tests support the weak and semistrong forms of the EMH
for well-developed markets such as the U.S. markets for large ¬rms™ stocks
and bond issues and for Treasury securities. Supporters of these forms of
the EMH note that there are some 100,000 or so full-time, highly trained
professional analysts and traders operating in these markets. Furthermore,
many of these analysts and traders work for businesses such as Citigroup,
Fidelity Investments, Merrill Lynch, Prudential, and the like, which have
billions of dollars available to take advantage of undervalued securities. Finally,
as a result of disclosure requirements and electronic information networks,
new information about heavily followed securities is almost instantaneously
available. Therefore, security prices in these markets adjust almost immediately
as new developments occur, and hence prices re¬‚ect all publicly available
information, including information on past price movements.
Virtually no one, however, believes that the strong form of the EMH
holds. Studies of legal purchases and sales by individuals with inside infor-
mation indicate that insiders can make abnormal pro¬ts by trading on that
information. It is even more apparent that insiders can make abnormal pro¬ts
if they trade illegally on speci¬c information that has not been disclosed to the
public, such as a takeover bid, a research and development breakthrough, and
the like.
The EMH has important implications both for securities investment
decisions and for business ¬nancing decisions. Because security prices appear
to generally re¬‚ect all public information, most actively followed and traded
securities are in equilibrium and fairly valued. Being in equilibrium, however,
does not mean that new information could not cause a security™s price to soar
or to plummet, but it does mean that most securities are neither undervalued
nor overvalued. Therefore, in the short run, for example, a year, an investor
can only expect to earn a return that is the same as the average for securities
of equal risk. Over the long run, an investor with no inside information can
only expect to earn a return on a security that compensates him or her for
the amount of risk assumed. In other words, investors should not expect to
“beat the market” after adjusting for risk. Also, because the EMH applies to
most bond markets, bond prices, and hence interest rates, re¬‚ect all current
public information. Consistently forecasting future interest rates is impossi-
ble because interest rates change in response to new information, and this
information could either lower or raise rates.
For managers, the EMH indicates that managerial decisions generally
should not be based on perceptions about the market™s ability to properly
price the ¬rm™s securities or on perceptions about the direction of future
interest rates. In other words, managers should not try to time security issues
382 Healthcare Finance

to try to catch stock prices while they are high or interest rates while they are
low. However, in some situations, managers may have information about their
own ¬rms that is unknown to the public. This condition is called asymmetric
information, which can affect managerial decisions. For example, suppose a
drug manufacturer has made a breakthrough in AIDS research but wants
to maintain as much secrecy as possible about the new drug. During ¬nal
development and testing, the ¬rm might want to delay any new securities
offerings because securities could probably be sold under more favorable
terms once the announcement is made. Managers can, and should, act on
inside information for the bene¬t of their ¬rms, but inside information cannot
legally be used for personal pro¬t.
Are markets really ef¬cient? If markets were not ef¬cient, the better
managers of stock and bond mutual funds and pension plans would be able to
consistently outperform the broad averages over long periods of time. In fact,
very few managers can consistently better the broad averages, and during most
years, mutual fund managers, on average, underperform the market. In any
year, some mutual fund managers will outperform the market and others will
underperform the market”this is known with certainty. But for an investor
to beat the market by investing in mutual funds, he or she must identify the
successful managers beforehand, which seems very dif¬cult, if not impossible,
to do.
In spite of the evidence, many theorists, and even more Wall Street
experts, believe that pockets of inef¬ciency do exist. In some cases, entire
markets may be inef¬cient. For example, the markets for the securities issued
by small ¬rms may be inef¬cient because there are neither enough analysts fer-
reting out information on these companies nor suf¬cient numbers of investors
trading these securities. Many people even believe that individual securities
traded in ef¬cient markets are occasionally priced inef¬ciently or that investor
emotions can drive prices too high during good times or too low during bad
times. For example, the stock market “bubble” of the late 1990s. Indeed, if
investors are driven more by greed and emotion than by rational assessments
of security values, it may be that markets are not really as ef¬cient as claimed
by supporters of the EMH.
We really don™t know whether it is possible to beat the market by skill
or whether it is just a matter of luck. Nevertheless, it is wise for both investors
and managers to consider the implications of market ef¬ciency when making
investment and ¬nancing decisions. If investors want to believe that they can
beat the market, ¬ne, but they should at least recognize that there is a lot of
evidence that tells us that most people who try will ultimately fail.

Self-Test 1. What two conditions must hold for markets to be ef¬cient?
Questions 2. Brie¬‚y, what is the Ef¬cient Markets Hypothesis (EMH)?
3. What are the implications of the EMH for investors and managers?
Chapter 12: Equity Financing

The Risk/Return Trade-Off
Most ¬nancial decisions involve alternative courses of action. For example,
should a hospital invest its excess funds in Treasury bonds that yield 6 percent
or in HCA bonds that yield 9 percent? Should a group practice buy a replace-
ment piece of equipment now or wait until next year? Should a joint venture
outpatient diagnostic center purchase a small, limited-use MRI system or a
large, and more expensive, multipurpose system?
Generally, such alternative courses of action will have different expected
rates of return, and one may be tempted to automatically accept the alternative
with the higher expected return. However, this approach to ¬nancial decision
making would be incorrect. In ef¬cient markets, those alternatives that offer
higher returns will also entail higher risk. The correct question to ask when
making ¬nancial decisions is not which alternative has the higher expected
rate of return, but which alternative has the higher return after adjusting for
risk. In other words, which alternative has the higher return over and above
the return commensurate with that alternative™s riskiness?
To illustrate the risk/return trade-off, suppose HCA stock has an ex-
pected rate of return of 14 percent, while its bonds yield 9 percent. Does
this mean that investors should ¬‚ock to buy the ¬rm™s stock and ignore the
bonds? Of course not. The higher expected rate of return on the stock merely
re¬‚ects the fact that the stock is riskier than the bonds. Those investors who
are not willing to assume much risk will buy HCA™s bonds, while those that are
less risk averse will buy the stock. From the perspective of HCA™s managers,
¬nancing with stock is less risky than using debt, so the ¬rm is willing to pay
the higher cost of equity to limit the ¬rm™s risk exposure.
In spite of the ef¬ciency of major securities markets, the markets for
products and services (i.e., the markets for real assets such as MRI systems)
are usually not ef¬cient; hence, returns are not necessarily related to risk. Thus,
hospitals, group practices, and other healthcare businesses can make real-asset
investments and achieve returns in excess of those required by the riskiness of
the investment. Furthermore, the market for innovation (i.e., the market for
ideas) is not ef¬cient. Thus, it is possible for people like Bill Gates, the founder
of Microsoft, to become multibillionaires at a relatively young age. However,
when excess returns are found in the product, service, or idea markets, new
entrants quickly join the innovators, and competition over time will usually
force rates of return down to ef¬cient market levels. The result is that later
entrants can only expect to earn returns that are commensurate with the risks

1. Explain the meaning of the term risk/return trade-off.
2. In what markets does this trade-off hold?
384 Healthcare Finance

Key Concepts
This chapter contains a wealth of material on equity ¬nancing, including
valuation, the investment banking process, and market ef¬ciency. The key
concepts of this chapter are:
• The most important common stockholder rights are a claim on the ¬rm™s
residual earnings, control, and the preemptive right.
• New common stock may be sold by for-pro¬t corporations in six ways: on
a pro rata basis to existing stockholders through a rights offering; through
investment bankers to the general public in a public offering ; to a single
buyer, or small number of buyers, in a private placement; to employees
through an employee stock purchase plan; to shareholders through a
dividend reinvestment plan; and to individual investors by direct purchase.
• A closely held corporation is one that is owned by a few individuals who
typically are the ¬rm™s managers.
• A publicly owned corporation is one that is owned by a relatively large
number of individuals, most of whom are not actively involved in its
• Securities markets are regulated at the national level by the Securities and
Exchange Commission (SEC) and the Federal Reserve Board, and at the
state level by state agencies that typically are called corporation commissions
(or something similar).
• An investment banker assists in the issuing of securities by helping the
business determine the size of the issue and the type of securities to be
used, by establishing the selling price, by selling the issue, and, in some
cases, by maintaining an after-market for the securities.
• Not-for-pro¬t ¬rms do not have access to the equity markets. However,
charitable contributions, which are tax deductible to the donor, and
governmental grants constitute unique equity sources for not-for-pro¬t
• The value of a share of stock of a dividend-paying company is found by
discounting the stream of expected dividends by the stock™s required rate of
• The value of a stock whose dividends are expected to grow at a constant
rate for many years is found by applying the constant growth model :

D0 — [1 + E(g)] E(D1 )
E(P0 ) = = .
R (Re ) ’ E(g) R (Re ) ’ E(g)
• The expected rate of return on a stock consists of an expected dividend yield
plus an expected capital gains yield. For a constant growth stock, both the
expected dividend yield and the expected capital gains yield are constant
over time and the expected rate of return can be found by this equation:

D0 — [1 + E(g)] E(D1 )
E(Re ) = + E(g) = + E(g).
P0 P0
Chapter 12: Equity Financing

• The Ef¬cient Markets Hypothesis (EMH) holds that (1) stocks are always in
equilibrium and fairly valued, (2) it is impossible for an investor to
consistently beat the market, and (3) managers should not try to forecast
future interest rates or time security issues.
• In ef¬cient markets, alternatives that offer higher returns must also have
higher risk; this is called the risk/return trade-off. The implication is that
investments must be evaluated on the basis of both risk and return.

The coverage of long-term ¬nancing continues in Chapter 13 with a discus-
sion of how managers choose between debt and equity ¬nancing. Additionally,
Chapter 13 also covers the cost of capital, an important concept that provides
the benchmark required rate of return used in capital investment analyses.

12.1 a. What is the preemptive right?
b. Why is it important to shareholders?
12.2 Why might an investor-owned ¬rm choose to issue different classes of
common stock?
12.3 Describe the primary means by which investor-owned ¬rms raise new
equity capital.
12.4 What are the similarities and differences between equity capital in
investor-owned ¬rms and fund capital in not-for-pro¬t ¬rms?
12.5 What is the general approach for valuing a share of stock of a dividend
paying company?
12.6 Two investors are evaluating the stock of Beverly Enterprises for
possible purchase. They agree on the stock™s risk and on expectations
about future dividends. However, one investor plans to hold the stock
for ¬ve years, while the other plans to hold the stock for 20 years.
Which of the two investors would be willing to pay more for the stock?
Explain your answer.
12.7 Evaluate the following statement: One of the assumptions of the
constant growth model is that the required rate of return must be
greater than the expected dividend growth rate. Because of this
assumption, the constant growth model is of limited use in the real
12.8 a. What is the Ef¬cient Markets Hypothesis (EMH)?
b. What are its implications for investors and managers?
12.9 a. What is meant by the term risk/return trade-off ?
b. Does this trade-off hold in all markets?

12.1 A person is considering buying the stock of two home health companies
that are similar in all respects except for the proportion of earnings paid
386 Healthcare Finance

out as dividends. Both companies are expected to earn $6 per share in
the coming year, but Company D (for dividends) is expected to pay
out the entire amount as dividends, while Company G (for growth)
is expected to pay out only one-third of its earnings, or $2 per share.
The companies are equally risky, and their required rate of return is 15
percent. D™s constant growth rate is zero and G™s is 8.33 percent. What
are the intrinsic values of Stocks D and G?
12.2 Medical Corporation of America (MCA) has a current stock price of
$36 and its last dividend (D0) was $2.40. In view of MCA™s strong
¬nancial position, its required rate of return is 12 percent. If MCA™s
dividends are expected to grow at a constant rate in the future, what is
the ¬rm™s expected stock price in ¬ve years?
12.3 A broker offers to sell you shares of Bay Area Healthcare, which just
paid a dividend of $2 per share. The dividend is expected to grow at a
constant rate of 5 percent per year. The stock™s required rate of return
is 12 percent.
a. What is the expected dollar dividend over the next three years?
b. What is the current value of the stock and the expected stock price
at the end of each of the next three years?
c. What is the expected dividend yield and capital gains yield for each
of the next three years?
d. • What is the expected total return for each of the next three years?
• How does the expected total return compare with the required
rate of return on the stock? Does this make sense? Explain your
12.4 Assume the risk-free rate is 6 percent and the market risk premium is
6 percent. The stock of Physicians Care Network (PCN) has a beta of
1.5. The last dividend paid by PCN (D0) was $2 per share.
a. What would PCN™s stock value be if the dividend was expected to
grow at a constant:
• ’5 percent?
• 0 percent?
• 5 percent?
• 10 percent?
b. What would be the stock value if the growth rate is 10 percent, but
PCN™s beta falls to:
• 1.0?
• 0.5?
12.5 Better Life Nursing Home, Inc., has maintained a dividend payment of
$4 per share for many years. The same dollar dividend is expected to be
paid in future years. If investors require a 12 percent rate of return on
investments of similar risk, determine the value of the company™s stock.
12.6 Jane™s sister-in-law, a stockbroker at Invest, Inc., is trying to get Jane
to buy the stock of HealthWest, a regional HMO. The stock has a
Chapter 12: Equity Financing

current market price of $25, its last dividend (D0) was $2.00, and
the company™s earnings and dividends are expected to increase at a
constant growth rate of 10 percent. The required return on this stock
is 20 percent. From a strict valuation standpoint, should Jane buy the
12.7 Lucas Clinic™s last dividend (D0) was $1.50. Its current equilibrium
stock price is $15.75, and its expected growth rate is a constant 5
percent. If the stockholders™ required rate of return is 15 percent, what
is the expected dividend yield and expected capital gains yield for the
coming year?
12.8 St. John Medical, a surgical equipment manufacturer, has been hit hard
by increased competition. Analysts predict that earnings and dividends
will decline at a rate of 5 percent annually into the foreseeable future.
If the ¬rm™s last dividend (D0) was $2.00, and investors™ required rate
of return is 15 percent, what will be the company™s stock price in three
12.9 California Clinics, an investor-owned chain of ambulatory care clinics,
just paid a dividend of $2 per share. The ¬rm™s dividend is expected to
grow at a constant rate of 5 percent per year, and investors require a 15
percent rate of return on the stock.
a. What is the stock™s value?
b. Suppose the riskiness of the stock decreases, which causes the
required rate of return to fall to 13 percent. Under these conditions,
what is the stock™s value?
c. Return to the original 15 percent required rate of return. Assume
that the dividend growth rate estimate is increased to a constant 7
percent per year. What is the stock™s value?


1. Some for-pro¬t ¬rms use preferred stock, which is a form of equity ¬nancing
that combines some features of both debt and equity. However, few healthcare
businesses use preferred stock ¬nancing, so this type of equity will not
be covered here. For more information on preferred stock, see Louis C.
Gapenski, Understanding Healthcare Financial Management (Chicago: Health
Administration Press, 2003), Chapter 6.
2. Traditionally, dividend paying corporations have paid them quarterly. However,
some corporations are now paying dividends annually. The advantage to
annual dividends is the reduction in administrative costs associated with paying
3. If a ¬rm is experiencing temporary ¬nancial dif¬culties, it might even borrow the
funds necessary to pay the dividend expected by stockholders rather than lower
or omit the payment.
4. For more details on the mechanics of a rights offering, see Eugene F. Brigham
388 Healthcare Finance

and Michael C. Ehrhardt, Financial Management: Theory and Practice (Ft.
Worth, TX: Harcourt College Publishers, 2002), Chapter 19.
5. Large security issues are announced in the Wall Street Journal and other
publications by advertisements called tombstones. Check several recent issues of
the Journal to see if any healthcare issues are advertised.
6. Although rare, some types of not-for-pro¬t corporations can sell shares to raise
capital. However, such “stock” does not pay dividends and cannot be sold
at a pro¬t. This form of not-for-pro¬t corporation is used mostly to ¬nance
not-for-pro¬t clinics, whereby the physicians that will practice in the clinic
contribute the start-up capital. When a physician leaves the clinic, his or her
initial capital investment is returned.
7. Stocks generally pay dividends quarterly, so theoretically they should be evaluated
on a quarterly basis. However, in stock valuation, most analysts work on an
annual basis because the data are not precise enough in most situations to
warrant the re¬nement of a quarterly model.
8. For more information on nonconstant growth stock valuation, see Eugene F.
Brigham and Michael C. Ehrhardt, Financial Management: Theory and Practice
(Ft. Worth, TX: Harcourt College Publishers, 2002), Chapter 10.

Dunn, K. C., G. B. Shields, and J. B. Stern. 1991. “The Dynamics of Leveraged Buy-
Outs, Conversions, and Corporate Reorganizations of Not-For-Pro¬t Health
Care Institutions.” Topics in Health Care Financing (Spring): 5“20.
Flaherty, M. P. 1991. “Planned Giving Programs as a Source of Financing: Creating a
˜Win-Win™ Situation for a Health Care Organization and Its Donors.” Topics
in Health Care Financing (Fall): 70“81.
Shields, G. B., and G. C. McKann. 1991. “Raising Health Care Capital Through the
Public Equity Markets.” Topics in Health Care Financing (Fall): 21“36.
Sykes, C. S., Jr. 1991. “The Role of Equity Financing in Today™s Health Care Envi-
ronment.” Topics in Health Care Financing (Fall): 1“4.
Wallace, C. 1985. “Not-For-Pro¬ts Competing for Capital by Selling Stock in Alter-
native Ventures.” Modern Healthcare (August 16): 32“38.


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

• Explain the effects of debt ¬nancing on a business™s risk and return.
• Discuss the factors that in¬‚uence the choice between debt and
equity ¬nancing.
• Describe the general process for estimating a business™s corporate
cost of capital.
• Estimate the component costs as well as the overall (corporate) cost
of capital for any healthcare business.
• Explain the economic interpretation of the corporate cost of capital
and how it is used in capital investment decisions.

In several previous chapters, we have noted that businesses use two inherently
different sources of capital: debt and equity. In this chapter, we discuss two
key issues related to ¬nancing: the choice between debt and equity and the
overall cost of capital to the business.

Capital Structure Basics
The mix of debt and equity ¬nancing used by a business is called its capital
structure, which is, in reality, the structure of the liabilities and equity side of
the business™s balance sheet. One of the most perplexing issues facing health
services organizations is how much debt ¬nancing, as opposed to equity (or
fund) ¬nancing, should a business use? Is there an optimal mix of debt and
equity (i.e., is there an optimal capital structure)? If optimal capital structures
do exist, do hospitals have different optimal structures than home health
agencies or ambulatory surgery centers? If so, what are the factors that lead to
these differences? These questions, although dif¬cult to answer, are important
to the ¬nancial well-being of any business.1

390 Healthcare Finance

Self-Test 1. What is a business™s capital structure?
Questions 2. What is meant by the term capital structure decision?

Impact of Debt Financing on Accounting Risk and Return
To fully understand the consequences of capital structure decisions, it is essen-
tial to understand the effects of debt ¬nancing on a business™s risk and return
as re¬‚ected in its ¬nancial statements. Consider the situation that faces Super
Health, Inc., a for-pro¬t (investor-owned) company that is just being formed.
Its founders have identi¬ed two ¬nancing alternatives for the business: all eq-
uity (all common stock) and 50 percent debt.
Table 13.1 contains the business™s projected ¬nancial statements under
the two ¬nancing alternatives. To begin, consider the balance sheets shown in
the top portion of the table. Super Health requires $100,000 in current assets
and $100,000 in ¬xed assets to begin operations. The asset requirements for
any business depend on the nature and size of the business rather than on how
the business will be ¬nanced, so the asset side of the balance sheet in Table
13.1 is unaffected by the ¬nancing mix. However, the type of ¬nancing does
affect the liabilities and equity side. Under the all-equity alternative, Super
Health™s owners will put up the entire $200,000 needed to purchase the
assets. If 50 percent debt ¬nancing is used, the owners will contribute only
$100,000, with the remaining $100,000 obtained from creditors”say, a bank
loan with a 10 percent interest rate.
What is the impact of the two ¬nancing alternatives on Super
Health™s projected ¬rst year™s income statement? Revenues are projected to be
$150,000 and operating costs are forecasted at $100,000, so the ¬rm™s oper-
ating income is expected to be $50,000. Because a business™s capital structure
does not affect revenues and operating costs, the operating income projection
is the same under both ¬nancing alternatives.
However, interest expense must be paid if debt ¬nancing is used. Thus,
the 50 percent debt alternative results in a 0.10 — $100,000 = $10,000
annual interest charge, while no interest expense occurs if the ¬rm is all-
equity ¬nanced. The result is taxable income of $50,000 under the all-equity
alternative and a lower taxable income of $40,000 under the 50 percent
debt alternative. Because the business anticipates being taxed at a 40 percent
federal-plus-state rate, the expected tax liability is 0.40 — $50,000 = $20,000
under the all-equity alternative and 0.40 — $40,000 = $16,000 for the 50
percent debt alternative. Finally, when taxes are deducted from the income
stream, the business expects to earn $30,000 in net income if it is all-equity
¬nanced and $24,000 in net income if 50 percent debt ¬nancing is used.
At ¬rst glance, the use of debt ¬nancing appears to be the inferior alter-
native. After all, if 50 percent debt ¬nancing is used, the business™s projected
net income will fall by $30,000 ’ $24,000 = $6,000. But the conclusion that
Chapter 13: Capital Structure and the Cost of Capital

TABLE 13.1
All Equity 50% Debt
Super Health,
Inc.: Projected
Balance Sheets:
Current assets $ 100,000 $ 100,000
Fixed assets 100,000 100,000
Under Two
Total assets $200,000 $ 200,000
Bank loan (10% cost) $ 0 $ 100,000 Alternatives
Common stock 200,000 100,000
Total liabilities and equity $200,000 $ 200,000

Income Statements:
Revenues $ 150,000 $ 150,000
Operating costs 100,000 100,000
Operating income $ 50,000 $ 50,000
Interest expense 0 10,000
Taxable income $ 50,000 $ 40,000
Taxes (40%) 20,000 16,000

Net income $ 30,000 $ 24,000

ROE 15% 24%

Total dollar return to investors $ 30,000 $ 34,000

debt ¬nancing is bad requires closer examination. What is most important to
the owners of Super Health is not the business™s net income but the return
expected on their equity investment. The best measure of return to the own-
ers of a business is the rate of return on equity (ROE)”de¬ned as net income
divided by the book value of equity. Under all-equity ¬nancing, the projected
ROE is $30,000 / $200,000 = 0.15 = 15%, but with 50 percent debt ¬nanc-
ing, projected ROE increases to $24,000 / $100,000 = 24%. The key to the
increased ROE is that although net income decreases when debt ¬nancing
is used, so does the amount of equity needed, and the capital requirement
decreases proportionally more than does net income.
The bottom line of this preliminary analysis is that debt ¬nancing can
increase owners™ expected rate of return. Because the use of debt ¬nancing
increases, or leverages up, the return to equityholders, such ¬nancing is often
called ¬nancial leverage. Hence, the use of ¬nancial leverage is merely the use
of debt ¬nancing.
To view the impact of ¬nancial leverage from a different perspective,
take another look at the Table 13.1 income statements. The total dollar return
to all investors, including both the owners and the bank, is $30,000 in net
income when all-equity ¬nanced but $24,000 in net income plus $10,000 of
392 Healthcare Finance

interest = $34,000 when 50 percent debt ¬nancing is used. Thus, the use
of debt ¬nancing increased the projected total dollar return to investors by
$34,000 ’ $30,000 = $4,000. Where did the extra $4,000 come from? The
answer is from the taxman. Taxes are $20,000 if the business is all-equity
¬nanced but only $16,000 when debt ¬nancing is used, and $4,000 less in
taxes means $4,000 more for investors. Because the use of debt ¬nancing
reduces taxes, more of a ¬rm™s operating income is available for distribution
to investors.2
At this point, it appears that Super Health™s ¬nancing decision is a
“no brainer.” Given only these two ¬nancing alternatives, 50 percent debt
¬nancing should be used because it promises owners the higher rate of return.
Unfortunately, like the proverbial no free lunch, there is a catch. The use of
¬nancial leverage not only increases owners™ projected return, it also increases
their risk.
To demonstrate the risk-increasing characteristics of debt ¬nancing,
consider Table 13.2, which recognizes that Super Health, like all businesses,
is risky. The ¬rst year™s revenues and operating costs listed in Table 13.1
are not known with certainty but are expected values taken from probability
distributions. Super Health™s founders believe that operating income could be
as low as zero or as high as $100,000 in the business™s ¬rst year of operation.
Furthermore, there is a 25 percent chance of the worst and the best cases
occurring, and a 50 percent chance that the Table 13.1 forecast, with an
operating income of $50,000, will be realized.
The assumptions regarding uncertainty in the future pro¬tability of the
business lead to three different ROEs for each ¬nancing alternative. The ex-
pected ROEs are the same as when uncertainty was ignored (i.e., 15 percent if
the ¬rm is all-equity ¬nanced and 24 percent when 50 percent debt ¬nancing
is used). For example, the expected ROE under all-equity ¬nancing is (0.25 —

TABLE 13.2
All Equity 50% Debt
Super Health,
Probability 0.25 0.50 0.25 0.25 0.50 0.25
Inc.: Partial
Income Operating income $0 $50,000 $100,000 $ 0 $50,000 $100,000
Statements in an Interest expense 0 0 0 10,000 10,000 10,000
Uncertain World Taxable income $0 $50,000 $100,000 ($10,000) $40,000 $ 90,000
Taxes (40%) 0 20,000 40,000 (4,000) 16,000 36,000

Net income $0 $30,000 $ 60,000 ($ 6,000) $24,000 $ 54,000

ROE 0% 15% 30% 24% 54%
Expected ROE 15% 24%
Standard deviation
of ROE 10.6% 21.2%
Chapter 13: Capital Structure and the Cost of Capital

0%) + (0.50 — 15%) + (0.25 — 30%) = 15.0%. However, the uncertainty in
operating income produces uncertainty, and hence risk, in the owners™ return.
If owners™ risk is measured by the standard deviation of ROE (stand-alone
risk), the return is twice as risky in the 50 percent debt ¬nancing alternative:
21.2 percent standard deviation of ROE versus 10.6 percent standard devia-
tion in the zero debt alternative.3
The increase in risk is apparent without even calculating the standard
deviations. If all equity ¬nancing is used, the worst return that can occur
is a ROE of zero. However, with 50 percent debt ¬nancing, a ROE of ’6
percent can occur. In fact, with no operating income to pay the $10,000
interest to the bank in the worst case scenario, the owners would either have to
put up additional equity capital to pay the interest due (assuming insuf¬cient
deprecation cash ¬‚ow) or declare the business bankrupt. Clearly, the use of 50
percent debt ¬nancing has increased the riskiness of the owners™ investment.
This simple example illustrates two key points about the use of debt

1. A business™s use of debt ¬nancing increases the percentage return to
owners (ROE).4
2. At the same time that return is increased, the use of debt ¬nancing also
increases owners™ risk. In the Super Health example, 50 percent debt
¬nancing doubled the owners™ risk as measured by standard deviation of

When risk is considered, the ultimate decision on which ¬nancing al-
ternative should be chosen is not so clear-cut. The zero debt alternative has a
lower expected ROE but also lower risk. The 50 percent debt alternative offers
a higher expected ROE but carries with it more risk. Thus, the decision is a
classic risk/return trade-off: higher returns can be obtained only by assuming
greater risk. What Super Health™s founders need to know is whether or not
the higher return is enough to compensate them for the higher risk assumed.
To complicate the decision even more, there are an almost unlimited number
of debt level choices available, not just the 50/50 mix used in the illustration.
This example vividly illustrates that health services managers face a dif¬cult
decision in setting a business™s optimal capital structure.

1. What is the impact of debt ¬nancing on owners™ rate of return?
2. What is the impact of debt ¬nancing on owners™ risk?
3. What is the basis for choosing the optimal level of debt ¬nancing?

Capital Structure Theory
At the end of the previous section, Super Health™s founders were left in
a quandary because debt ¬nancing brings with it both higher returns and
394 Healthcare Finance

higher risk. Capital structure theory, which was developed for investor-owned
businesses, attempts to resolve this dilemma. If the relationship between the
use of debt ¬nancing and equity value (stock price) were known, then the
optimal capital structure could be identi¬ed.
There are many competing theories of capital structure, but one theory
”the trade-off theory”is most widely accepted. In general, this theory tells
managers that an optimal capital structure does exist for every business. Fur-
thermore, the optimal structure balances the tax advantages of debt ¬nancing
against the increased risk that arises when debt ¬nancing is used. The trade-off
theory is summarized in Figure 13.1. Here, the proportion of debt in a ¬rm™s
capital structure is plotted on the X axis, while the Y axis plots the costs of
debt and equity as well as the combined cost of both ¬nancing sources. The
focus in Figure 13.1 is not on the absolute level of debt ¬nancing but rather
on the proportion of debt ¬nancing used”larger ¬rms have higher dollar val-
ues of debt than do smaller ¬rms. Furthermore, growing ¬rms add additional
amounts of both debt and equity to their balance sheets on a regular basis. In
Figure 13.1, we assume that the business™s assets are held constant, and what
changes, and hence what is shown on the X axis, is the proportion of debt: 0
percent (i.e., no debt), 10 percent, 20 percent, and so on, up to 100 percent
(i.e., all debt).
To begin, consider the relationship between the cost of debt and pro-
portion of debt ¬nancing. As a business uses a greater proportion of debt
¬nancing, the risk to creditors increases because the greater the debt service
requirement, the higher the probability that default will occur. In essence,
the greater the proportion of debt ¬nancing, the riskier the lender™s position.
Thus, the cost of debt (i.e., the interest rate) increases as the proportion of
debt increases. However, the cost of debt increases slowly at low and moderate
proportions of debt because the incremental risk to lenders is relatively small,
but then it increases at a faster rate as even more debt is used. Thus, in Figure
13.1 the cost of debt line ¬rst rises slowly, and then, as more and more debt
is used, rises at a faster and faster rate.
As discussed in the Super Health illustration, the use of debt ¬nancing
also increases the risk to equityholders. Furthermore, the greater the propor-
tion of debt, the greater the risk. Thus, the cost of equity also increases with
the proportion of debt ¬nancing, just as does the cost of debt. The primary
difference between the cost of debt and the cost of equity curves is not their
shape but where they are located on the graph. The cost of equity is higher
than the cost of debt because owners face more risk than do creditors. (Eq-
uityholders have a residual claim on the earnings of the ¬rm, while creditors™
claims are ¬xed by contract.) Furthermore, the cost of debt is lowered even
more relative to equity because interest payments are tax deductible while
returns to equityholders are not. Thus, as shown in Figure 13.1, the cost of
equity is appreciably greater than the cost of debt at any level of debt.
In practice, ¬rms tend to use some, but not all, debt ¬nancing, so
Chapter 13: Capital Structure and the Cost of Capital

Theory of
Capital Structure

¬rms actually use a blend of the two major sources of ¬nancing. Under these
conditions, what is most relevant to ¬nancing decisions is not just the cost
of debt or just the cost of equity but the weighted average (blended) cost of
the two components. The weighted average cost is shown on the graph as a
dotted line labeled “average cost of capital.” At zero debt (the Y axis), the
¬rm is all-equity ¬nanced, so its average cost of capital is simply its cost of
equity. When a business ¬rst starts using debt ¬nancing, it adds a lower cost
component to its capital structure, and hence the average cost of ¬nancing
decreases. However, as the proportion of debt ¬nancing increases, both the
cost of equity and the cost of debt increase, and at an increasing rate. At
some point, the increasing component costs outweigh the fact that more of
the lower-cost debt component is being used, and the average cost of capital
bottoms out. Beyond this point, the average cost of capital begins to increase.
The point at which the average cost of capital is minimized de¬nes
the ¬rm™s optimal capital structure. At this structure, overall ¬nancing costs
are minimized. Capital, like labor, is an input to the ¬rm, and the ¬rm™s
¬nancial condition is maximized at any given output when its input costs are
minimized. Once the optimal capital structure, or perhaps an optimal range,
396 Healthcare Finance

has been identi¬ed for a business, its managers will ¬nance asset acquisitions
in a way that keeps the ¬rm at its optimal structure. Thus, the optimal capital
structure becomes the target for future ¬nancing. For this reason, a ¬rm™s
optimal capital structure is also called its target capital structure.
Although theory indicates that an optimal capital structure exists, it
turns out that it is not easy in practice to identify this structure for any given
business. However, there is some good news associated with Figure 13.1.
Empirical studies con¬rm that the average cost-of-capital curve, similar to
the one plotted in the ¬gure, has a relatively shallow shape. Thus, variations
in debt usage from the optimal structure do not have a signi¬cant impact
on capital costs, and hence it is not essential that managers identify exactly a
business™s optimal structure. Furthermore, even if a precise optimal structure
could be identi¬ed, relatively large movements away from this structure, which
commonly occur in practice, will not materially affect ¬nancial performance.

Self-Test 1. What is the relationship between a business™s use of debt ¬nancing and
Questions its cost of debt? Its cost of equity? Its overall cost of capital?
2. How is the optimal capital structure de¬ned?
3. Is it critical that the precise structure be identi¬ed and followed?

Identifying the Optimal Capital Structure in Practice
Unfortunately, capital structure theory cannot provide managers with the op-
timal capital structure for a given business because the component costs, par-
ticularly the cost of equity, cannot be estimated with any con¬dence at differ-
ent capital structures. Thus, health services managers must apply judgment in
making the capital structure decision. The judgmental analysis involves sev-
eral different factors, and in one situation a particular factor may have great
importance, while the same factor may be relatively unimportant in another
situation. Here are some of the more important judgmental issues that man-
agers consider in setting a business™s target capital structure.

Business Versus Financial Risk
Businesses have a certain amount of risk, called business risk, inherent in
operations even when no debt ¬nancing is used. This risk is associated with
the ability of managers to forecast future pro¬tability. The more dif¬cult the
forecasting process, the greater the inherent risk of the business. To illustrate,
refer to Table 13.2. Super Health™s business risk can be measured by the
standard deviation of ROE assuming the ¬rm uses zero debt ¬nancing.
Thus, the business risk of Super Health is 10.6 percent. If no debt ¬nancing is
used, return on equity is equal to return on assets, so business risk is measured
by the inherent uncertainty in the return on a business™s assets.
Chapter 13: Capital Structure and the Cost of Capital

When debt ¬nancing is used, equityholders must bear additional risk.
In a capital structure context, the risk added when debt ¬nancing is used is
called ¬nancial risk. For Super Health, the standard deviation of ROE when
50 percent debt ¬nancing is used is 21.2 percent. The difference between
the standard deviations of ROE with and without debt ¬nancing measures
the amount of ¬nancial risk. Thus, for Super Health, the ¬nancial risk at 50
percent debt ¬nancing is 21.2% ’ 10.6% = 10.6%. Using a mix of half debt
and half equity doubles the risk to the owners of a business as measured by
the standard deviation of ROE.
In general, managers will place some limit on the total amount of risk,
including both business and ¬nancial, undertaken by a business. Thus, the
greater the inherent business risk, the less “room” available for the use of
¬nancial leverage and hence the lower the proportion of debt used.

Lender and Rating Agency Attitudes
Regardless of a manager™s own analysis of the proper capital structure for his
or her ¬rm, there is no question that lenders™ and rating agencies™ attitudes are
frequently important determinants of ¬nancial structures. In the majority of
situations, corporate managers discuss the business™s ¬nancial structure with
lenders and rating agencies and give much weight to their advice. Often, man-
agers want to maintain some target debt rating”say, single A. Furthermore,
rating agencies publish guidelines that link ¬rms™ capital structures within an
industry to speci¬c bond ratings, so guidance is readily available.
If a particular ¬rm™s management is so con¬dent of the future that it
seeks to use debt ¬nancing beyond the norms of its industry, lenders may be
unwilling to accept such debt levels or may do so only at a high price. In
effect, lenders and rating agencies set an absolute limit on the proportion of
debt ¬nancing that can be used by any business.

Reserve Borrowing Capacity
Firms generally maintain a reserve borrowing capacity that preserves the abil-
ity to issue debt when conditions so dictate. In essence, managers want to
maintain ¬nancial ¬‚exibility, which is de¬ned in a capital structure context
as the ability to access, at any time, alternative forms of capital under reason-
able terms. For example, suppose Merck had just successfully completed an
R&D program on a new drug and its internal projections forecast much higher
earnings in the future. However, the new earnings are not yet anticipated by
investors and hence are not re¬‚ected in the price of its stock. If Merck needed
additional capital, its managers would not want to issue stock; they would
prefer to ¬nance with debt until the higher earnings materialized and were
re¬‚ected in the stock price. Then, they could sell an issue of common stock,
retire the debt, and return the ¬rm to its target capital structure. To maintain
this reserve borrowing capacity, businesses generally use less debt than other
factors may indicate should be used.
398 Healthcare Finance

Industry Averages
Presumably, managers act rationally, so the capital structures of other ¬rms in
the industry, particularly the industry leaders, should provide insights about
the optimal structure. In general, there is no reason to believe that the man-
agers of one ¬rm are better than the managers of another ¬rm. Thus, if one
¬rm has a capital structure that is signi¬cantly different from other ¬rms in its
industry, the managers of that ¬rm should identify the unique circumstances
that contribute to the anomaly. If unique circumstances cannot be identi¬ed,
then it is doubtful that the ¬rm has identi¬ed the correct target structure.

Asset Structure
Firms whose assets are suitable as security for loans pay lower interest rates on
debt ¬nancing than do other ¬rms and hence tend to use more debt. Thus,
hospitals tend to use more debt than do companies involved in technological
research. Both the ability to use assets as collateral and low inherent business
risk give a ¬rm more debt capacity, and hence a target capital structure that
includes a relatively high proportion of debt.

Self-Test 1. Is the capital structure decision mostly objective or subjective?
Questions 2. What is the difference between business and ¬nancial risk?
3. What are some of the factors that managers must consider when setting
the target capital structure?

Not-for-Pro¬t Businesses
The discussion of capital structure has focused on investor-owned businesses.
What about not-for-pro¬t corporations? The same general concepts apply”
namely, some debt ¬nancing is good, but too much is bad. However, not-for-
pro¬t ¬rms have a unique problem”they cannot go to the capital markets
to raise equity capital. If an investor-owned ¬rm has more capital investment
opportunities than it can ¬nance with retained earnings and debt ¬nancing,
it can always raise the needed funds by a new stock issue. It may be costly,
but it can be done. Additionally, it is quite easy for investor-owned ¬rms
to adjust their capital structures. If they are ¬nancially underleveraged (i.e.,
using too little debt), they can simply issue more debt and use the proceeds to
repurchase stock. On the other hand, if they are ¬nancially overleveraged (i.e.,
using too much debt), they can issue additional equity and use the proceeds
to refund debt.
Not-for-pro¬t ¬rms do not have access to the equity markets; their
sources of equity capital consist of government grants, private contributions,
and excess revenues (retained earnings). Managers of not-for-pro¬t organiza-
tions do not have the same degree of ¬‚exibility in either capital investment
or capital structure decisions as do their proprietary counterparts. Thus, it
Chapter 13: Capital Structure and the Cost of Capital

is sometimes necessary for not-for-pro¬t ¬rms to delay new projects, even
pro¬table ones, because of funding insuf¬ciencies or to use more than the
theoretically optimal amount of debt because that is the only way that needed
services can be ¬nanced.
Although such actions may be required in certain situations, not-for-
pro¬t managers must recognize that these strategies increase costs. Project
delays mean that needed services are not being provided on a timely basis.
Using more debt than optimal pushes the ¬rm beyond the point of the greatest
net bene¬t of debt ¬nancing, and hence capital costs are increased above the
minimum. If a not-for-pro¬t ¬rm is forced into a situation where it is using
more than the optimal amount of debt ¬nancing, its managers should reduce
the ¬rm™s level of debt as soon as the situation permits.
The ability of a not-for-pro¬t business to garner governmental grants,
attract private contributions, and generate earnings plays an important role
in establishing its competitive position. A ¬rm that has an adequate amount
of equity (fund) capital can operate at its optimal capital structure and thus
minimize capital costs. If insuf¬cient equity capital is available, too much ¬-
nancial leverage is then used, and the result is higher capital costs. To illustrate
this point, consider two not-for-pro¬t hospitals that are similar in all respects,
except that one has more equity capital and can operate at its optimal struc-
ture while the other has insuf¬cient equity capital and thus must use more
debt ¬nancing than optimal. In effect, the hospital with insuf¬cient equity
must operate at an inef¬cient capital structure. The former has a signi¬cant
competitive advantage because it can either offer more services at the same
cost by using additional, nonoptimal debt ¬nancing or it can offer matching
services at lower costs.
Suf¬cient equity capital provides not-for-pro¬t businesses with the ¬‚ex-
ibility to offer all of the necessary services and still operate at the lowest capital
cost structure. Like companies that have low operating cost structures, not-
for-pro¬t ¬rms that have low capital cost structures”that is, operating at their
optimal capital structures”have an advantage over their competitors that have
higher capital cost structures.

1. What unique problems do managers of not-for-pro¬t businesses face
regarding capital structure decisions?
2. Why is capital structure important to the managers of not-for-pro¬t

Cost of Capital Basics
In the ¬rst part of this chapter, the discussion focused on choosing between
debt and equity ¬nancing. Once that decision is made, the business will raise
capital over time in such a way as to maintain (or move toward) its optimal
400 Healthcare Finance

(target) structure. Of course, other considerations also come into play when
raising new capital, but, over the long run, businesses will attempt to keep
their capital structures close to the target.
Now, we turn our attention to identifying the speci¬c costs of maintain-
ing that structure. The ultimate goal of the cost of capital estimation process is
to estimate a business™s corporate cost of capital, which represents the blended,
or average, cost of a business™s ¬nancing. This cost, in turn, is used as the
required rate of return, or hurdle rate, when evaluating the business™s capital
investment opportunities. For example, assume Bayside Memorial Hospital
has a corporate cost of capital of 10 percent. If a new MRI investment, which
has been judged to have average risk, is expected to return at least 10 per-
cent, then it is ¬nancially attractive to the hospital. If the MRI is expected
to return less than 10 percent, accepting it will have an adverse effect on the
hospital™s ¬nancial soundness. In effect, the corporate cost of capital sets the
opportunity cost rate for new capital investment.
The corporate cost of capital is a weighted average of the component
(i.e., debt and equity) costs. After the component costs have been estimated,
they are combined to form the corporate cost of capital. Thus, the ¬rst step
in the cost of capital estimation process is to estimate both the cost of debt
and the cost of equity. However, before we discuss the mechanics of cost es-
timation, some other issues regarding the corporate cost of capital estimation
process must be considered.

The Capital Components
The ¬rst task in estimating a business™s corporate cost of capital is to determine
which sources of capital on the liabilities and equity side of the balance sheet
should be included in the estimate. In general, the corporate cost of capital
focuses on the cost of permanent capital (long-term capital) because these are
the sources used to ¬nance capital asset acquisitions. Thus, for most ¬rms, the
relevant capital components are equity and long-term debt. Typically, short-
term debt is used only as temporary ¬nancing to support seasonal or cyclical
¬‚uctuations in volume, and hence it is not included in the cost of capital
estimate. However, if a ¬rm does use short-term debt as part of its permanent
¬nancing mix, then such debt should be included. As discussed in Chapter
16, the use of short-term debt to ¬nance permanent assets is highly risky and
is not common under normal conditions.

Tax Effects
In developing component costs, the issue of taxes arises for investor-owned
companies. Should the component costs be estimated on a before- or after-
tax basis? As discussed in the previous section on capital structure, the use of
debt ¬nancing creates a tax bene¬t because interest expense is tax deductible,
while the use of equity ¬nancing has no impact on taxes. This tax bene¬t can
be handled in several ways when working with capital costs, but the most
Chapter 13: Capital Structure and the Cost of Capital

common way is to include it in the cost of capital estimate. Thus, the tax
bene¬t associated with debt ¬nancing will be recognized in the component
cost of debt estimate, resulting in an after-tax cost of debt. For not-for-pro¬t
¬rms, the bene¬t that arises from the issuance of tax-exempt debt will be
incorporated directly in the cost estimate because investors require a lower
interest rate on tax-exempt (municipal) debt.

Historical Versus Marginal Costs
Two very different sets of capital costs can be measured: (1) historical, or
embedded, costs, which re¬‚ect the cost of funds raised in the past, and (2)
new, or marginal, costs, which measure the cost of funds to be raised in
the future. Historical costs are important for many purposes. For example,
payers that reimburse on a cost basis are concerned with embedded costs.
However, the primary purpose in estimating a ¬rm™s corporate cost of capital
is to use it in making capital investment decisions, which involve future asset
acquisitions and future ¬nancing. Thus, for purposes here the relevant costs
are the marginal costs of new funds to be raised during some future planning
period”say, a year”and not the cost of funds raised in the past.

1. What is the basic concept of the corporate cost of capital?
2. What ¬nancing sources are typically included in a ¬rm™s cost of capital
3. Should the component costs be estimated on a before- or an after-tax
4. Should the component costs re¬‚ect historical or marginal costs?

Cost of Debt Capital
It is unlikely that a ¬rm™s managers will know at the start of a planning period
the exact types and amounts of debt that will be issued in the future; the type
of debt actually used will depend on the speci¬c assets to be ¬nanced and
on market conditions as they develop over time. However, a ¬rm™s managers
do know what types of debt the ¬rm usually issues. For example, Bayside
Memorial Hospital (a not-for-pro¬t hospital) typically uses bank debt to raise
short-term funds to ¬nance seasonal or cyclical working capital needs and uses
30-year tax-exempt bonds to raise long-term debt capital. Because Bayside
does not use short-term debt to ¬nance permanent assets, its managers include
only long-term debt in their corporate cost of capital estimate, and they
assume that this debt will consist solely of 30-year tax-exempt bonds.
Suppose that Bayside™s managers are developing the hospital™s corpo-
rate cost of capital estimate for the coming year. How should they estimate
the hospital™s component cost of debt ? Bayside™s managers would begin by
discussing current and prospective interest rates with the ¬rm™s investment
402 Healthcare Finance

bankers, the institutions that help companies bring security issues to market.
Assume that the municipal bond analyst at Suncoast Securities, Inc., Bay-
side™s investment banker, states that a new 30-year tax-exempt healthcare is-
sue would require semiannual interest payments of $30.50 ($61 annually)
for each $1,000 par value bond issued. Thus, municipal bond investors cur-
rently require a $61 / $1,000 = 0.061 = 6.1% return on Bayside™s 30-year
The true cost of the issue to Bayside would be somewhat higher than
6.1 percent because the hospital must incur administrative expenses, or ¬‚ota-
tion costs, to sell the bonds. However, such expenses are typically small on
bond issues, so their impact on the cost of debt estimate is inconsequential,
especially when the uncertainty inherent in the entire cost of capital estima-
tion process is considered. Therefore, it is common practice to ignore ¬‚otation
costs when estimating debt costs. Bayside follows this practice, so its managers
would estimate the component cost of debt as 6.1 percent:

Tax-exempt component cost of debt = R (R d) = 6.1%.

If Bayside™s currently outstanding debt were actively traded, then the
current yield to maturity (YTM) on this debt could be used to estimate
the cost of new debt. Using the yield to maturity on an outstanding issue
to estimate the cost of new debt works reasonably well when the remaining
life of the old issue approximates the anticipated maturity of the new issue. If
this is not the case, then yield curve differentials may cause the estimate to be
biased. For example, if the yield curve is upward sloping in the 15- to 30-year
range, the yield to maturity on a 15-year outstanding issue would understate
the actual cost of new 30-year debt.
What about smaller businesses that do not have relationships with
investment bankers and do not have publicly traded debt? If a business obtains
the bulk of its debt ¬nancing from commercial banks, then the ¬rm™s bankers
will be able to provide some insights on the cost of future debt ¬nancing.
Alternatively, managers can look to marketplace activity for guidance; that is,
the interest rate currently being set on debt issues of similar-risk ¬rms can be
used as an estimate of the cost of debt. Here, similar risk can be judged either
by debt rating or by subjective analysis (same industry, similar size, similar use
of debt, and so on). Also, the prime rate gives small businesses a benchmark
for bank loan rates. If the business has borrowed from commercial banks in
the past, its managers will know the historical premium charged above the
prime rate for the business™s bank debt. An awareness of the current interest
rate environment generally permits managers to make a reasonable estimate
for their own business™s cost of debt, even when the business is quite small.
A taxable healthcare provider would use one or more of the techniques
just described to estimate its before-tax cost of debt. However, the tax bene¬ts
of interest payments must then be incorporated into the estimate. To illus-
Chapter 13: Capital Structure and the Cost of Capital

trate, consider Ann Arbor Health Systems, Inc., an investor-owned company
that operates 16 acute care hospitals in Michigan, Indiana, and Ohio. The
company™s investment bankers indicate that a new 30-year taxable bond issue
would require a yield of 11.0 percent. Because the ¬rm™s federal-plus-state tax
rate is 40 percent, its component cost of debt estimate is 6.6 percent:

Taxable component cost of debt = R (Rd ) — (1 ’ T)
= 11.0% — (1 ’ 0.40)
= 11.0% — 0.60 = 6.6%.
The component cost of debt to an investor-owned ¬rm is an after-tax cost
because the effective cost to the ¬rm is reduced by the (1 ’ T) term. By
reducing Ann Arbor™s component cost of debt from 11.0 percent to 6.6
percent, the cost of debt estimate has incorporated the bene¬t associated with
interest payment tax deductibility.
In general, the effective cost of debt is roughly comparable between
investor-owned and not-for-pro¬t ¬rms of similar risk. Investor-owned ¬rms
have the bene¬t of tax deductibility of interest payments, while not-for-pro¬t
¬rms have the bene¬t of being able to issue lower interest-rate tax-exempt

1. What are some methods used to estimate a ¬rm™s cost of debt?
2. What is the impact of ¬‚otation costs on the cost of debt? Are these costs
generally material?
3. For investor-owned ¬rms, how is the before-tax cost of debt converted
to an after-tax cost?

Cost of Equity Capital
Investor-owned businesses raise equity capital by selling new common stock
and by retaining earnings for use by the ¬rm rather than paying them out
as dividends to shareholders. Not-for-pro¬t businesses raise equity capital
through contributions and grants, and by generating an excess of revenues
over expenses, none of which can be paid out as dividends. In the follow-
ing sections, we describe how to estimate the cost of equity capital both to
investor-owned and not-for-pro¬t businesses.6

Cost of Equity to Investor-Owned Businesses
The cost of debt is based on the return that investors require on debt securities,
and the cost of equity to investor-owned businesses can be de¬ned similarly: It
is the rate of return that investors require on the ¬rm™s common stock. This
concept is clear when new common stock is sold, but it may appear that equity
raised through retained earnings is costless. The reason why a cost of capital
404 Healthcare Finance

must be assigned to all forms of equity ¬nancing involves the opportunity
cost principle. An investor-owned ¬rm™s net income literally belongs to its
common stockholders. Employees are compensated by wages, suppliers are
compensated by cash payments for supplies, bondholders are compensated by
interest payments, governments are compensated by tax payments, and so on.
The residual earnings of a ¬rm, its net income, belongs to the stockholders
and serves to “pay the rent” on stockholder-supplied capital.
Management can either pay out earnings in the form of dividends or
retain earnings for reinvestment in the business. If part of the earnings is
retained, an opportunity cost is incurred: stockholders could have received
these earnings as dividends and then invested this money in stocks, bonds,
real estate, commodity futures, and so on. Thus, the ¬rm should earn on its
retained earnings at least as much as its stockholders themselves could earn on
alternative investments of similar risk. If the ¬rm cannot earn as much as
stockholders can in similar risk investments, then the ¬rm™s net income should
be paid out as dividends rather than retained for reinvestment within the ¬rm.
What rate of return can stockholders expect to earn on other investments of
equivalent risk? The answer is R(Re)”the required rate of return on equity.
Investors can earn this return either by buying more shares of the ¬rm in
question or by buying the stock of similar ¬rms.
Three primary methods may be used by investor-owned businesses to
estimate the cost of equity: the Capital Asset Pricing Model (CAPM), the
discounted cash ¬‚ow (DCF) model, and the debt cost plus risk premium
model. These methods should not be regarded as mutually exclusive because
no single approach dominates the estimation process. In practice, all three
approaches (if applicable) should be used to estimate the cost of equity, and
then the ¬nal value should be chosen on the basis of ones con¬dence in the
data at hand.

Capital Asset The Capital Asset Pricing Model (CAPM), which was introduced in Chapter
Pricing Model 10, is a widely accepted ¬nance model that speci¬es the equilibrium risk/
(CAPM) return relationship on common stocks. Basically, the model assumes that
Approach investors consider only one risk factor when setting required rates of returns”
the volatility of returns on the stock compared with the volatility of returns on
a well-diversi¬ed stock portfolio called the market portfolio, or just the market.
The measure of risk in the CAPM is the stock™s market beta.
Within the CAPM, the actual equation that relates risk to return is the
Security Market Line (SML):

R (Re ) = RF + [R (RM ) ’ RF] — b
= RF + (RPM — b).
Managers can estimate the required rate of return on the ¬rm™s stock, R(Re),
given estimates of the risk-free rate, RF, the beta of the stock, b, and the
Chapter 13: Capital Structure and the Cost of Capital

required rate of return on the market, R(RM). This estimate, in turn, can be
used as the estimate for the ¬rm™s cost of equity.
The starting point for the CAPM cost of equity estimate is the risk-
free rate. Unfortunately, there is no security in the United States that is truly
riskless. Treasury securities are essentially free of default risk, but long-term
T-bonds will suffer capital losses if interest rates rise, and a portfolio invested
in short-term T-bills will provide a volatile earnings stream because the rate
paid on T-bills varies over time. Because a truly riskless rate cannot be found
in practice, what rate should be used? The preference, shared by most ¬nance
professionals, is to use the rate on long-term Treasury bonds.
There are many reasons for favoring the T-bond rate, including the fact
that T-bill rates are very volatile because they are directly affected by actions
taken by the Federal Reserve Board. Perhaps the most persuasive argument is
that common stocks are generally viewed as long-term securities, and although
a particular stockholder may not have a long investment horizon, the majority
of stockholders do invest on a long-term basis. Therefore, it is reasonable to
think that stock returns embody long-term in¬‚ation expectations similar to
those embodied in bonds rather than the short-term in¬‚ation expectations
embodied in bills. On this account, the cost of equity should be more highly
correlated with T-bond rates than with T-bill rates. T-bond rates can be found
in local newspapers, in the Wall Street Journal, and in numerous Web sites.
Generally, the yield on 20-year T-bonds is used as the proxy for the risk-
free rate.
The required rate of return on the market, and its derivative, the market
risk premium, RPM = R(RM) ’ RF, can be estimated on the basis of either


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