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historical returns or expected returns. The most widely used set of historical
market returns is provided by Ibbotson Associates. Their data, which are
published annually, includes annual rates of return on stocks, T-bills, T-bonds,
and a set of high-grade corporate bonds.7 In recent years, the historical market
The last parameter needed for a CAPM cost of equity estimate is the
stockā™s beta coefļ¬cient. Unfortunately, beta measures how risky a stock was
in the past, whereas investors are interested in future risk. It may be that a
given company was judged to be quite safe in the past, but that things have
changed and its future risk is judged to be higher than its past risk, or vice
versa. In general, is future risk sufļ¬ciently similar to past risk to warrant the
use of historical betas in a CAPM framework? For individual ļ¬rms, historical
betas are often not very stable, so past risk is often not a good predictor of
future risk.8
Furthermore, betas can be calculated over different time periods and
different measures for the market return can be used, so different ļ¬nancial
advisory services report different betas for the same company. The choice is a
matter of judgment and data availability, for there is no right beta. With luck,
the betas derived from different sources will, for a given company, be close
406 Healthcare Finance

together. If they are not, conļ¬dence in the CAPM cost of equity estimate will
be diminished.
To illustrate the CAPM approach, consider Ann Arbor Health Systems,
which has a beta coefļ¬cient, b, of 1.14. Furthermore, assume that the current
yield on T-bonds, RF, is 6.0 percent and that the best estimate for the current
market risk premium, RPM, is 7.0 percentage points. In other words, the
current required rate of return on the market, R(RM), is 6.0% + 7.0% = 13.0%.
All the required input parameters have been estimated, so the SML equation
can be completed as follows:

R (Re ) = RF + [R (RM ) ā’ RF] Ć— b
= 6.0% + (13.0% ā’ 6.0%) Ć— 1.14
= 6.0% + (7.0% Ć— 1.14)
= 6.0% + 8.0% = 14.0%.
Thus, according to the CAPM, Ann Arborā™s required rate of return on equity
is 14.0 percent.
In words, what does the 14.0 percent estimate for R(Re) imply? In
essence, equity investors believe that Ann Arborā™s stock, with a beta of 1.14,
is slightly more risky than the average stock, with a beta of 1.00. With a risk-
free rate of 6.0 percent, and a market risk premium of 7.0 percentage points,
an average company, with b = 1.0, has a required rate of return on equity
of 6.0% + (7.0% Ć— 1.00) = 6.0% + 7.0% = 13.0%. Thus, according to the
CAPM, equity investors require 100 basis points more return to invest in Ann
Arbor Health Systems, with b = 1.14, than they require to invest in an average
stock, with b = 1.00.
There is a great deal of uncertainty in the CAPM estimate of the cost of
equity. Some of this uncertainty stems from the fact that there is no assurance
that the CAPM is correctā”that is, that the CAPM accurately describes the
risk/return choices of stock investors. Additionally, there is a great deal of
uncertainty in the input parameter estimates, especially the required rate of
return on the market and the beta coefļ¬cient. Because of these uncertainties,
it is highly unlikely that Ann Arborā™s true, but unobservable, cost of equity is
14.0 percent. Thus, instead of picking single values for each parameter, it may
be better to develop high and low estimates, and then to combine all of the
high estimates and all of the low estimates to develop a range, rather than a
point estimate, for R(Re).

Discounted The second procedure for estimating the cost of equity is the discounted cash
Cash Flow ļ¬‚ow (DCF) approach, which uses the dividend valuation model as its basis. As
(DCF) Approach we discussed in Chapter 12, if the company has an established track record
of paying dividends and if the dividend is expected to grow each year at a
407
Chapter 13: Capital Structure and the Cost of Capital

constant rate, E(g), then the constant growth model can be used to estimate
the expected rate of return on the stock, E(Re):

D0 Ć— [1 + E(g)] E(D1 )
E(Re ) = + E(g) = + E(g).
P0 P0
Because stock prices typically are in equilibrium, the expected rate of return,
E(Re), is also the required rate of return, R(Re).
As in the CAPM approach, there are three input parameters in the DCF
model. Current stock price, P0, is readily available for ļ¬rms that are actively
(OTC) market, so its stock price can easily be determined. At the time of the
analysis, Ann Arborā™s stock price was \$40.
Next yearā™s dividend payment, E(D1), is also relatively easy to estimate.
Ann Arborā™s managers can obtain this estimate from the ļ¬rmā™s ļ¬ve-year ļ¬nan-
cial plan. For an outsider, dividend data on larger publicly traded ļ¬rms are
available from brokerage houses and investment advisory ļ¬rms. Ann Arbor
Health Systems is followed by several analysts at major brokerage houses, and
their consensus estimate for next yearā™s dividend payment is \$2.50, so for
purposes of this analysis, E(D1) = \$2.50. If next yearā™s dividend estimate is
not available, the current dividend, D0, along with the expected growth rate
can be used to make the estimate.
The dividend growth rate is the most difļ¬cult of the DCF model
parameters to estimate. Although historical earnings and dividend data can
be analyzed directly to estimate growth rates, most ļ¬nance professionals rely
on expert analysts for growth rate estimates. Analysts forecast and then publish
growth rate estimates for most of the larger publicly owned companies. For
example, Value Line provides such forecasts on about 1,700 companies, and
all of the larger brokerage houses provide similar forecasts. Furthermore,
several companies compile analystsā™ forecasts on a regular basis and provide
summary information such as the median and range of forecasts on widely
followed companies. These growth rate summaries, such as the one compiled
by Lynch, Jones & Ryan in its Institutional Brokers Estimate System (IBES),
can be ordered for a fee and obtained either in hardcopy format or as online
electronic data.
However, analystsā™ forecasts often assume nonconstant growth. For ex-
ample, analysts who follow Ann Arbor Health Systems, on average, forecasted
a 12.0 percent annual growth rate in earnings and dividends over the next ļ¬ve
years, followed by a steady-state growth rate of 6.5 percent. A rough way to
handle this situation is to use the nonconstant growth forecast to develop
a proxy constant growth rate. Computer simulations indicate that dividends
beyond Year 50 contribute very little to the value of any stockā”the present
value of dividends beyond Year 50 is virtually zero, so it is reasonable to ig-
nore dividends beyond that point. If only a 50-year horizon is considered, a
408 Healthcare Finance

weighted average growth rate can be developed and used as a constant growth
rate for cost of capital purposes. For Ann Arbor Health Systems, the growth
rate of 12.0 percent for ļ¬ve years was assumed to be followed by a growth
rate of 6.5 percent for 45 years, which produced an arithmetic average annual
growth rate of (0.10 Ć— 12.0%) + (0.90 Ć— 6.5%) = 7.2%. This ļ¬gure, together
with other estimates, leads to the conclusion that Ann Arbor Health Systemā™s
expected dividend growth rate is in the range of 7.0 to 8.0 percent.9
To illustrate the DCF approach, consider the data developed thus far
for Ann Arbor Health Systems. The companyā™s current stock price, P0, is \$40,
and its next expected annual dividend, E(D1), is \$2.50. Thus, the ļ¬rmā™s DCF
estimate of R(Re), according to the DCF model is:

E(D1 )
R (Re ) = + E(g)
P0
\$2.50
= + E(g) = 6.3% + E(g).
\$40
With an E(g) estimate range of 7 to 8 percent, the midpoint, 7.5 percent, will
be used as the ļ¬nal estimate. Thus, the DCF estimate for Ann Arbor Health
Systemā™s cost of equity is 6.3% + 7.5% = 13.8%.

Debt Cost Plus The debt cost plus risk premium approach relies on the fact that stock invest-
Risk Premium ments are riskier than debt investments; hence the cost of equity for any busi-
Approach ness can be thought of as the cost of debt to that business plus a risk premium:

R (Re ) = R (Rd ) + Risk premium.
The cost of debt is relatively easy to estimate, so the key input to this model
Note that the risk premium used here is not the same as the market
risk premium used in the CAPM. The market risk premium is the amount that
investors require above the risk-free rate to invest in an average risk common
stock. Here, we need the risk premium above the ļ¬rmā™s own cost of debt.
How might this new risk premium be estimated? Using the data from above,
we know that the cost of equity for an average risk (b = 1.0) stock is 13.0
percent. Furthermore, the cost of debt for an average ļ¬rm, which has roughly
an A rating, is 9.0 percent. Thus, for an average ļ¬rm, the risk premium of the
cost of equity over the cost of debt is 13.0% ā’ 9.0% = 4.0 percentage points.
Empirical work suggests that the risk premium for use in the debt
cost plus risk premium model has ranged from 4 to 7 percentage points, so
our current estimate is consistent with historical results. Perhaps the biggest
weakness of this approach is that there is no assurance that the risk premium for
the average ļ¬rm is the same as the risk premium for the ļ¬rm in question, which
in this case is Ann Arbor Health Systems. Thus, the risk premium method does
not have the theoretical precision that the other models do. On the other
409
Chapter 13: Capital Structure and the Cost of Capital

hand, the input values required by the debt cost plus risk premium model are
fewer and easier to estimate than in the other models, and hence it can be
used in situations where the other models cannot.
With a before-tax cost of debt estimate of 11.0 percent and a current
risk premium estimate of 4.0 percentage points, the debt cost plus risk pre-
mium estimate for Ann Arborā™s cost of equity is 15.0 percent:

R (Re ) = R (Rd ) + Risk premium
= 11.0% + 4.0% = 15.0%.

We have presented three methods for estimating the cost of equity. The CAPM Comparison of
estimate was 14.0 percent, the DCF estimate was 13.8 percent, and the debt the Three
cost plus risk premium estimate was 15.0 percent. At this point, judgment is Methods
required. Most analysts would conclude that there is sufļ¬cient consistency in
the CAPM and DCF results to warrant the use of 13.9 percent (the average
of the two) as the ļ¬nal estimate of Ann Arborā™s cost of equity. Thus, in this
example, we are ignoring the debt cost plus risk premium results. In general,
analysts must judge the relative merits of each estimate and then choose a ļ¬nal
estimate that seems most reasonable under the circumstances. In general, this
choice is made on the basis of the analystā™s conļ¬dence in the input parameters
of each approach.

Cost of Equity to Not-for-Proļ¬t Businesses
Not-for-proļ¬t businesses raise equity (fund) capital in two basic ways: (1) by
receiving contributions and grants and (2) by earning an excess of revenues
over expenses (retained earnings). In this section we ļ¬rst discuss some views
regarding the cost of fund capital, and then we illustrate how this cost might
be estimated.
Our primary purpose in this chapter is to develop a corporate cost of
capital estimate that can be used in making capital investment decisions. Thus,
the estimated ācostsā represent the cost of using capital to purchase ļ¬xed
assets, rather than for alternative uses. What is the cost of using equity capital
for real-asset investments within not-for-proļ¬t businesses? There are several
positions that can be taken on this question.10

ā¢ Fund capital has a zero cost. The rationale here is that (1) contributors
do not expect a monetary return on their contributions and (2) the ļ¬rmā™s
stakeholders, especially the patients who pay more for services than
warranted by the ļ¬rmā™s tangible costs, do not require an explicit return on
the capital retained by the ļ¬rm. With no explicit return required by the
suppliers of equity capital, the cost of that capital is zero.
ā¢ Fund capital has a cost equal to the return forgone on marketable
securities investments. When a not-for-proļ¬t ļ¬rm receives contributions
410 Healthcare Finance

or retains earnings, it can always invest these funds in marketable securities
(highly liquid, safe securities) rather than purchase real assets. Thus, fund
capital has a relatively low opportunity cost that should be acknowledged;
this cost is roughly equal to the return available on a portfolio of
short-term, low-risk securities such as T-bills.
ā¢ Fund capital has a cost equal to the expected growth rate of the
businessā™s assets.11 Assume that a hospital must increase its total assets by
8 percent per year to keep pace with an increasing patient load. To
purchase the required assets without increasing its proportion of debt
ļ¬nancing, the hospital must grow its fund capital at an 8 percent rate. In
this way, it can ļ¬nance asset growth by growing both debt and equity at
the same 8 percent rate and hence can hold the proportion of debt at its
target. If the hospital earned zero return on its existing fund capital, it
would be unable to add new assets without increasing its debt ratio or
relying on grants and contributions to provide the needed equity. Even if
no volume growth is expected, a not-for-proļ¬t business must earn a return
on its fund capital just to replace its existing asset base as assets wear out or
become obsolete, because new assets generally will cost more than the
ones being replaced and hence depreciation cash ļ¬‚ow in itself will not be
sufļ¬cient to replace assets as needed. The bottom line here is that
not-for-proļ¬t ļ¬rms must earn a return on equity merely to support dollar
growth in assets; and the greater the growth rate, including that caused by
inļ¬‚ation and technology improvements, the greater the return that must
be earned.
ā¢ Fund capital has a cost equal to that required to maintain the
businessā™s creditworthiness. One of the factors that rating agencies
consider when assigning debt ratings is the proļ¬tability of the
businessā”all else the same, the higher the proļ¬tability of the business the
better the credit rating. In general, managers of not-for-proļ¬t healthcare
businesses have some target debt rating that they seek to achieve (or
maintain). Furthermore, rating agencies publish proļ¬tability measures,
including return on equity, that they consider to be appropriate for each
debt rating. Thus, to maintain the businessā™s desired rating, managers
must achieve the return on equity recommended by the rating agencies,
which in turn sets the businessā™s cost of equity target.
ā¢ Fund capital has a cost equal to the cost of equity to similar for-proļ¬t
businesses. Like the ļ¬rst position, this position also rests on the
opportunity cost concept, but the opportunity cost is now deļ¬ned as the
return available from investing fund capital in alternative investments of
similar risk. To illustrate, suppose Bayside Memorial Hospital, a
not-for-proļ¬t corporation, receives \$500,000 in contributions in 2005
and also retains \$4.5 million in earnings, so it has \$5 million of new fund
capital available for investment. The \$5 million could be (1) used to
purchase assets related to its core business, such as an outpatient clinic; (2)
411
Chapter 13: Capital Structure and the Cost of Capital

temporarily invested in securities with the intent of purchasing healthcare
assets some time in the future; (3) used to retire debt; (4) used to pay
management bonuses; (5) placed in a non-interest-bearing account at the
bank; and on and on. By using this capital to invest in real assets, Bayside
is deprived of the opportunity to use this capital for other purposes, so an
opportunity cost must be assigned that reļ¬‚ects the riskiness associated
with an equity investment in hospital assets. What return is available on
securities with similar risk to hospital assets? The answer is the return
expected from investing in the stock of an investor-owned hospital
business, such as Ann Arbor Health Systems. Instead of using fund capital
to purchase real healthcare assets, Bayside could always use the funds to
buy the stock of a for-proļ¬t hospital corporation, and delay the real-asset
purchase until some time in the future.

With these ļ¬ve positions in mind, which one should prevail in practice?
Unfortunately, the answer is not clear-cut. Here are our views on this issue.
At a minimum, a not-for-proļ¬t business should require a return on its equity
investments in real assets that is as large as its projected asset growth rate. In
that way, the business is setting the minimum rate of return that will, if it is
actually achieved, ensure the ļ¬nancial stability of the organization. Thus, the
expected growth rate sets the minimum required rate of return, and hence the
minimum cost of equity, for not-for-proļ¬t businesses. However, if the rating
agency target return on equity is greater than the growth rate target, this value
should be used to maintain the businessā™s creditworthiness.
However, to fully recover all opportunity costs, including the op-
portunity cost of employing equity capital in healthcare assets, the real-asset
investments must offer an expected return equal to the return expected on
similar-risk securities investments. Thus, the ātrueā economic cost of equity
to a not-for-proļ¬t healthcare provider is the rate that could be earned on stock
investments in similar investor-owned ļ¬rms. Using this cost of equity, a not-
for-proļ¬t business is requiring that all costs, including full opportunity costs,
be considered in the cost of capital estimate.
Although we believe the āfull opportunity costā approach to be most
correct, many would argue that the unique mission of not-for-proļ¬t businesses
precludes securities investments as realistic alternatives to healthcare plant and
equipment because securities investments do not contribute directly to the
mission of providing healthcare services.
On the other hand, full opportunity costs do not have to be recovered
on every new capital investment undertaken. Not-for-proļ¬t businesses do
invest in projects that are beneļ¬cial in ways other than ļ¬nancial, so the cost
of capital estimate does not set an absolute limit on new investment. We
do believe, however, that healthcare managers should be aware of the true
ļ¬nancial opportunity costs inherent in capital investments, and the only way
412 Healthcare Finance

this can be accomplished is to use cost of equity to similar for-proļ¬t businesses
as the cost of fund capital.

Self-Test 1. What are the three primary methods for estimating a for-proļ¬t ļ¬rmā™s
Questions cost of equity?
2. What is the best proxy for the risk-free rate in the CAPM method? Why?
3. How would you choose between widely different cost of equity
estimates?
4. Why is there a cost associated with fund capital?
5. What is the cost of fund capital?

The Corporate Cost of Capital
The ļ¬nal step in the cost of capital estimation process is to combine the debt
and equity cost estimates to form the corporate cost of capital. As discussed
at the beginning of this chapter, each ļ¬rm has a target capital structure in
mindā”deļ¬ned as the particular mix of debt and equity that causes its average
cost of capital to be minimized. Furthermore, when a ļ¬rm raises new capital,
it generally tries to ļ¬nance in a way that will keep the actual capital structure
reasonably close to its target over time. Here is the general formula for the
corporate cost of capital (CCC) for all ļ¬rms, regardless of ownership:

CCC = [wd Ć— R (Rd ) Ć— (1 ā’ T)] + [we Ć— R (Re )].
Here wd and we are the target weights for debt and equity, respectively. The
cost of the debt component, R(Rd), will be an average if the ļ¬rm uses several
types of debt for its permanent ļ¬nancing. Alternatively, the above equation
could be expanded to include multiple debt terms. Investor-owned ļ¬rms
would use their marginal tax rate for T, while T would be zero for not-for-
proļ¬t ļ¬rms.
The corporate cost of capital represents the cost of each new dollar of
capital raised, rather than the average cost of all the dollars raised in the past.
Because the primary interest is in obtaining a cost of capital for use in capital
investment analysis; a marginal cost is required. Furthermore, the corporate
cost of capital formula implies that each new dollar of capital will consist of
both debt and equity that is raised, at least conceptually, in proportion to the
ļ¬rmā™s target capital structure.

The Corporate Cost of Capital for Investor-Owned Firms
To illustrate the corporate cost of capital calculation for investor-owned ļ¬rms,
consider Ann Arbor Health Systems, which has a target capital structure of 60
percent debt and 40 percent equity. As previously estimated, the companyā™s
before-tax cost of debt, R(Rd), is 11.0 percent; its tax rate, T, is 40 percent;
413
Chapter 13: Capital Structure and the Cost of Capital

and its cost of equity, R(Re) is 13.9 percent, so Ann Arborā™s corporate cost of
capital estimate is 9.5 percent:

CCC = [wd Ć— R (Rd ) Ć— (1 ā’ T)] + [we Ć— R (Re )]
= [0.60 Ć— 11.0% Ć— (1 ā’ 0.40)] + [0.40 Ć— 13.9%]
= 9.5%.
Conceptually, every dollar of new capital that Ann Arbor will obtain consists
of 60 cents of debt with an after-tax cost of 6.6 percent and 40 cents of equity
with a cost of 13.9 percent. The average cost of each new dollar is 9.5 percent.
In any one year, Ann Arbor may raise all its required new capital by issuing
debt, by retaining earnings, or by selling new common stock. But over the
long run, Ann Arbor plans to use 60 percent debt ļ¬nancing and 40 percent
equity ļ¬nancing, and these weights must be used in the corporate cost of
capital estimate regardless of the actual ļ¬nancing plans for the near term.

The Corporate Cost of Capital for Not-for-Proļ¬t Firms
The corporate cost of capital for not-for-proļ¬t businesses is developed in
the same way as for investor-owned ļ¬rms. To illustrate, the corporate cost
of capital for Bayside Memorial Hospital, assuming a target capital structure
of 50 percent debt and 50 percent equity, and using the estimates for the
component costs that were developed earlier, is 10 percent:

CCC = [wd Ć— R (Rd ) Ć— (1 ā’ T)] + [we Ć— R (Re )]
= [0.50 Ć— 6.1% Ć— (1 ā’ 0)] + [0.50 Ć— 13.9%]
= 10.0%.
Businesses, regardless of ownership, cannot raise unlimited amounts
of new capital in any given year at a constant cost. Eventually, for several
reasons, as more new capital is raised, investors will require higher returns on
debt and equity capital, even though the capital is raised in accordance with
the ļ¬rmā™s target structure. Thus, the corporate costs of capital, as estimated
here for Ann Arbor and Bayside, are only valid when the amount required for
capital investment falls within the ļ¬rmā™s normal range. If capital is required
in amounts that far exceed those normally raised, the corporate cost of capital
must be subjectively adjusted upward to reļ¬‚ect the higher costs involved.

Self-Test
1. What is the general formula for the corporate cost of capital?
Questions
2. What weights should be used in the formula? Why?
3. What is the primary difference between the corporate costs of capital
for investor-owned and not-for-proļ¬t ļ¬rms?
414 Healthcare Finance

4. Is the corporate cost of capital affected by short-term ļ¬nancing plans?
5. Is the corporate cost of capital constant regardless of the amount of new

An Economic Interpretation of the Corporate Cost of Capital
Thus far, the focus of the cost of capital discussion has been on the mechanics
of the estimation process. In closing, it is worthwhile to step back from
the mathematics of the process and examine the corporate cost of capitalā™s
economic interpretation.
The component cost estimates (the costs of debt and equity) that make
up a ļ¬rmā™s corporate cost of capital are based on the returns that investors
require to supply capital to the business. In turn, investorsā™ required rates of
return are based on the opportunity costs borne by investing in the debt and
equity of the ļ¬rm in question, rather than in alternative investments of similar
risk. These opportunity costs to investors, when combined into the ļ¬rmā™s
corporate cost of capital, establish the opportunity cost to the business; that
is, the corporate cost of capital is the return that the business could earn by
investing in alternative investments that have the same risk as its own real
assets. From a pure ļ¬nancial perspective, if a business (especially one that
is investor owned) cannot earn its corporate cost of capital on new capital
investments, no new investments should be made and no new capital should
be raised. If existing investments are not earning the corporate cost of capital,
they should be terminated, the assets liquidated, and the proceeds returned
to investors for reinvestment elsewhere.
However, the corporate cost of capital is not the appropriate minimum
rate of return for all new real-asset investments. The required rates of return
set by investors on the businessā™s debt and equity are based on perceptions
regarding the riskiness of their investments, which, in turn, are based on two
factors: (1) the inherent riskiness of the business (i.e., business risk) and (2) the
amount of debt ļ¬nancing used (i.e., ļ¬nancial risk). Thus, the ļ¬rmā™s inherent
business risk and capital structure are embedded in its corporate cost of capital
estimate.
Because different ļ¬rms have different business risk and use different
proportions of debt ļ¬nancing, different ļ¬rms have different corporate costs
of capital. Differential capital costs are most pronounced for ļ¬rms in different
industries. Still, even ļ¬rms in the same industry can have different business
risk, and capital structure differences among such ļ¬rms can compound cor-
porate cost of capital differences.
The primary purpose of estimating a businessā™s corporate cost of capital
is to help make capital budgeting decisions; that is, the cost of capital will
415
Chapter 13: Capital Structure and the Cost of Capital

be used as the benchmark capital budgeting hurdle rate, or minimum return
necessary for a project to be attractive ļ¬nancially. The ļ¬rm can always earn its
cost of capital by investing in selected stocks and bonds that in the aggregate
have the same risk as the ļ¬rmā™s assets, so it should not invest in real assets
unless it can earn at least as much. However, remember that the corporate
cost of capital reļ¬‚ects opportunity costs based on the aggregate risk of the
ļ¬rm (i.e., the riskiness of the ļ¬rmā™s average project). Thus, the corporate
cost of capital can be applied without modiļ¬cation only to those projects
under consideration that have average risk, where average is deļ¬ned as that
applicable to the ļ¬rmā™s currently held assets in the aggregate. If a project
under consideration has risk that differs signiļ¬cantly from that of the ļ¬rmā™s
average asset, then the corporate cost of capital must be adjusted to account
for the differential risk when the project is being evaluated.
To illustrate the concept, Bayside Memorial Hospitalā™s corporate cost
of capital, 10 percent, is probably appropriate for use in evaluating a new
outpatient clinic that has risk similar to the hospitalā™s average project, which
involves the provision of healthcare services. Clearly, it would not be appropri-
ate to apply Baysideā™s 10 percent corporate cost of capital without adjustment
to a new project that involves establishing a managed care subsidiary; this
project does not have the same risk as the hospitalā™s average asset.
As discussed in Chapter 10, investors require higher returns for riskier
investments. Thus, a high-risk project must have a higher project cost of capital
than a low-risk project. Figure 13.2 illustrates the relationship between project
risk, the corporate cost of capital, and project costs of capital. The ļ¬gure
illustrates that Baysideā™s 10 percent corporate cost of capital is the appropriate
hurdle rate only for an average risk project (Project A), where average means
a project that has the same risk as the aggregate business. Project L, which has
less risk than Baysideā™s average project has a project cost of capital, 8 percent,
that is less than the corporate cost of capital. Conversely, Project H, with
more risk than the average project, has a higher project cost of capitalā”12
percent.
The key point here is that the corporate cost of capital is merely a
benchmark that will be used as the basis for estimating project costs of capital.
It is not a one-size-ļ¬ts-all rate that can be used with abandon whenever an
opportunity cost is needed in a ļ¬nancial analysis. This point will be revisited
in Chapter 15 when capital investment risk considerations are addressed.
Finally, note that large businesses often have subsidiaries that operate
in diverse lines of business. When this situation exists, for capital investment
purposes it is best to estimate divisional costs of capital in addition to the cor-
porate cost of capital. Whereas the overall cost of capital reļ¬‚ects the aggregate
risk of the business, the divisional costs of capital reļ¬‚ect the unique risk (and
perhaps unique capital structure) of each division. (In Chapter 15, we explore
the divisional cost of capital concept in more detail.)
416 Healthcare Finance

FIGURE 13.2
Bayside
Memorial
Hospital:
Corporate and
Project Costs of
Capital

Self-Test 1. Explain the economic interpretation of the corporate cost of capital.
Questions 2. Is the corporate cost of capital the appropriate opportunity cost for all
3. Draw a graph similar to the one shown in Figure 13.2, and explain its
implications.
4. Should large businesses estimate divisional costs of capital? Explain your

Key Concepts
This chapter discusses optimal capital structure and the corporate cost of
capitalā”two very important concepts in healthcare ļ¬nance. The key
concepts of this chapter are:
ā¢ The choice between debt and equity ļ¬nancing is one type of risk/return
or, in not-for-proļ¬t ļ¬rms, the return on fund capital, but it also increases
ā¢ The optimal, or target, capital structure is that structure that minimizes
the average cost of capital to the business.
417
Chapter 13: Capital Structure and the Cost of Capital

ā¢ Unfortunately, ļ¬nance theory is of limited help in actually setting a ļ¬rmā™s
target structure. Thus, in making the capital structure decision, health
services managers must consider a wide range of factors, including the
following: business risk, lender and rating agency attitudes, reserve
borrowing capacity, industry averages, and asset structure.
ā¢ Managers of not-for-proļ¬t businesses must grapple with the same capital
structure decisions as the managers of investor-owned ļ¬rms. However,
not-for-proļ¬t ļ¬rms do not have the same ļ¬‚exibility in making ļ¬nancing
decisions because not-for-proļ¬t ļ¬rms cannot issue common stock.
ā¢ In estimating a ļ¬rmā™s corporate cost of capital, the component cost of debt is
the after-tax cost of new debt. For taxable ļ¬rms, it is found by multiplying
the before-tax cost of new debt by (1 ā’ T), where T is the ļ¬rmā™s marginal
tax rate, so the component cost of debt is R(Rd) Ć— (1 ā’ T). For
not-for-proļ¬t ļ¬rms, the debt is often tax-exempt, but no other tax effects
apply, so the component cost of debt is merely the tax-exempt R(Rd).
ā¢ The cost of equity to investor-owned ļ¬rms is the return that its
stockholders could obtain by investing in the stocks of similar-risk
companies. It usually is estimated by using three methods: the Capital
Asset Pricing Model (CAPM) approach, the discounted cash ļ¬‚ow (DCF)
approach, and the debt cost plus risk premium approach.
ā¢ For not-for-proļ¬t ļ¬rms, the cost of equity (fund capital) can be estimated
in two ways. First, the full opportunity cost approach uses the cost of equity
of similar investor-owned ļ¬rms. Second, the minimum cost of equity
approach uses the expected growth rate of the business (or the return on
equity target set by rating agencies.
ā¢ Each ļ¬rm has a target capital structure, and the target weights are used to
estimate the ļ¬rmā™s corporate cost of capital (CCC):

CCC = [wd Ć— R (Rd ) Ć— (1 ā’ T)] + [we Ć— R (Re )].
ā¢ When making capital investment decisions, a business will use the
corporate cost of capital as the hurdle rate for average-risk projects. A
ļ¬rm with divisions that operate in diverse line of business should use
divisional costs of capital for the same purpose.

The concepts developed in this chapter play a vital role in making capital
investment decisions and hence will be revisited in Chapters 14 and 15.

Questions
13.1 Critique this statement: āThe use of debt ļ¬nancing lowers the net
income of the ļ¬rm, and hence debt ļ¬nancing should be used only as a
last resort.ā
418 Healthcare Finance

13.2 Discuss some factors that health services managers must consider when
setting a ļ¬rmā™s target capital structure. Consider both investor-owned
13.3 Is the corporate cost of capital estimate based on historical or marginal
costs? Why?
13.4 What capital components are typically included when estimating a
ļ¬rmā™s corporate cost of capital?
13.5 How may a ļ¬rmā™s cost of debt be estimated?
13.6 a. Why is there a cost to retained earnings in investor-owned
b. What are the three methods commonly used to estimate the cost of
equity?
c. Is the risk premium in the CAPM the same as the risk premium in
the debt cost plus risk premium model?
d. How would you estimate the cost of equity (fund capital) for a
13.7 What is the economic interpretation of the corporate cost of capital?
13.8 Is the corporate cost of capital the same for all ļ¬rms? Explain your
13.9 For any given ļ¬rm, can the corporate cost of capital be used as the

Problems
13.1 Seattle Health Plans currently uses zero debt ļ¬nancing. Its operating
income (EBIT) is \$1 million, and it pays taxes at a 40 percent rate. It
has \$5 million in assets and, because it is all-equity ļ¬nanced, \$5 million
in equity. Suppose the ļ¬rm is considering replacing half of its equity
ļ¬nancing with debt ļ¬nancing bearing an interest rate of 8 percent.
a. What impact would the new capital structure have on the ļ¬rmā™s net
b. Redo the analysis, but now assume that the debt ļ¬nancing would
cost 15 percent.
c. Return to the initial 8 percent interest rate. Now, assume that EBIT
could be as low as \$500,000 (with a probability of 20 percent) or
as high as \$1.5 million (with a probability of 20 percent). There
remains a 60 percent chance that EBIT would be \$1 million. Redo
the analysis for each level of EBIT, and ļ¬nd the expected values for
What lesson about capital structure and risk does this illustration
provide?
d. Repeat the analysis required for Part a, but now assume that Seattle
Health Plans is a not-for-proļ¬t corporation and hence pays no taxes.
Compare the results with those obtained in Part a.
419
Chapter 13: Capital Structure and the Cost of Capital

13.2 Calculate the after-tax cost of debt for the Wallace Clinic, a for-proļ¬t
healthcare provider, assuming that the coupon rate set on its debt is 11
percent and its tax rate is:
a. 0 percent
b. 20 percent
c. 40 percent
13.3 St. Vincentā™s Hospital has a target capital structure of 35 percent debt
and 65 percent equity. Its cost of equity (fund capital) estimate is 13.5
percent and its cost of tax-exempt debt estimate is 7 percent. What is
the hospitalā™s corporate cost of capital?
13.4 Richmond Clinic has obtained the following estimates for its costs of
debt and equity at various capital structures:

Percent Debt After-Tax Cost of Debt Cost of Equity
0% ā” 16.0%
20 6.6 17.0
40 7.8 19.0
60 10.2 22.0
80 14.0 27.0

What is the ļ¬rmā™s optimal capital structure? (Hint: Calculate its
corporate cost of capital at each structure. Also, note that data on
component costs at alternative capital structures are not reliable in
real-world situations.)
13.5 Medical Associates is a large for-proļ¬t group practice. Its dividends
are expected to grow at a constant rate of 7 percent per year into the
foreseeable future. The ļ¬rmā™s last dividend (D0) was \$2, and its current
stock price is \$23. The ļ¬rmā™s beta coefļ¬cient is 1.6; the rate of return
on 20-year T-bonds currently is 9 percent; and the expected rate of
return on the market, as reported by a large ļ¬nancial services ļ¬rm, is
13 percent. The ļ¬rmā™s target capital structure calls for 50 percent debt
ļ¬nancing, the interest rate required on the businessā™s new debt is 10
percent, and its tax rate is 40 percent.
a. What is Medical Associatesā™s cost of equity estimate according to the
DCF method?
b. What is the cost of equity estimate according to the CAPM?
c. On the basis of your answers to Parts a and b, what would be your
ļ¬nal estimate for the ļ¬rmā™s cost of equity?
d. What is your estimate for the ļ¬rmā™s corporate cost of capital?
13.6 Morningside Nursing Home, a not-for-proļ¬t corporation, is estimating
its corporate cost of capital. Its tax-exempt debt currently requires an
interest rate of 6.2 percent and its target capital structure calls for 60
percent debt ļ¬nancing and 40 percent equity (fund capital) ļ¬nancing.
The estimated costs of equity for selected investor-owned healthcare
companies are given below:
420 Healthcare Finance

Glaxo Wellcome 15.0%
Beverly Enterprises 16.4
HEALTHSOUTH 17.4
Humana 18.8

a. What is the best estimate for Morningsideā™s cost of equity?
b. What is the ļ¬rmā™s corporate cost of capital?
13.7 Golden State Home Health, Inc., is a large, California-based for-proļ¬t
home health agency. Its dividends are expected to grow at a constant
rate of 5 percent per year into the foreseeable future. The ļ¬rmā™s last
dividend (D0) was \$1, and its current stock price is \$10. The ļ¬rmā™s beta
coefļ¬cient is 1.2; the rate of return on 20-year T-bonds currently is 8
percent; and the expected rate of return on the market, as reported by a
large ļ¬nancial services ļ¬rm, is 14 percent. Golden Stateā™s target capital
structure calls for 60 percent debt ļ¬nancing, the interest rate required
on its new debt is 9 percent, and the ļ¬rmā™s tax rate is 30 percent.
a. What is the ļ¬rmā™s cost of equity estimate according to the DCF
method?
b. What is the cost of equity estimate according to the CAPM?
c. On the basis of your answers to Parts a and b, what would be your
ļ¬nal estimate for the ļ¬rmā™s cost of equity?
d. What is your estimate for the ļ¬rmā™s corporate cost of capital?

Notes
1. In this book, we present only an overview of the capital structure decision.
Financial Management: Theory and Practice (Fort Worth, TX: Harcourt College
Publishers, 2002), Chapters 16 and 17.
2. Our illustration does not address the impact of debt ļ¬nancing on not-for-proļ¬t
ļ¬rms. Here are the income statements assuming zero taxes:
Stock Stock/Debt
Revenues \$150,000 \$150,000
Operating costs 100,000 100,000
Operating income \$ 50,000 \$ 50,000
Interest expense 0 10,000
Net income \$ 50,000 \$ 40,000

ROE 25% 40%

We see here that the use of debt also leverages up the return on ownership capital
in not-for-proļ¬t ļ¬rms. Note, however, that the interest rate on tax-exempt debt
would be lower than the rate we used here, so the advantage of debt ļ¬nancing is
actually greater than this illustration suggests.
3. If we examined the impact of debt ļ¬nancing on portfolio (market) risk, as
opposed to stand-alone risk, we would get the same result. Namely, the use of
debt ļ¬nancing increases the beta of the stock and hence the riskiness seen by
equity investors.
421
Chapter 13: Capital Structure and the Cost of Capital

4. For the use of debt ļ¬nancing to increase ownersā™ rate of return, the inherent
return on the business must be greater than the interest rate on the debt. The
basic return on the business in the Super Health illustration is 25 percent (\$50
in operating income divided by \$200 in assets), and debt ļ¬nancing costs only 10
percent, so the use of debt ļ¬nancing increases ROE.
5. A question arises here as to whether the stated rate or the effective annual rate
should be used in the cost of debt estimate. In general, the difference will be
inconsequential, so most ļ¬rms opt for the easier approach, which is simply to
use the stated rate. (The effective annual rate in this example is [1.0305]2 ā’
1.0 = 6.19% versus a 6.1 percent stated rate.) More importantly, most capital
budgeting analyses use end-of-year cash ļ¬‚ows to proxy cash ļ¬‚ows that occur
throughout the year, in effect creating nominal cash ļ¬‚ows. For consistency, we
prefer to use a nominal (stated) cost of capitalā”the cash ļ¬‚ows will be understated
but so will the cost of capital.
6. Only a few ļ¬rms in the health services industry use preferred stock ļ¬nancing, so
we will not include preferred stock in our cost of capital examples. If preferred
stock is used as a source of permanent ļ¬nancing, then it should be included in
the cost of capital estimate, and its cost would be estimated using procedures
similar to those discussed for the cost of debt.
7. See Stocks, Bonds, Bills and Inļ¬‚ation: 2004 Yearbook (Chicago: Ibbotson
Associates, 2004).
8. Because historical betas may not be good predictors of future risk, researchers
have sought ways to improve them. This has led to the development of two
other types of betas: (1) adjusted betas and (2) fundamental betas. Adjusted betas
recognize the fact that true betas tend to move toward 1.0 over time. Therefore,
one can begin with a ļ¬rmā™s pure historical statistical beta, make an adjustment
for the expected future movement toward 1.0, and produce an adjusted beta
that on average will be a better predictor of the future beta than would the
to include such fundamental risk variables as the use of debt ļ¬nancing, sales
volatility, and the like. These betas are constantly adjusted to reļ¬‚ect changes in a
ļ¬rmā™s operations and capital structure, whereas with historical betas (including
adjusted ones) such changes might not be fully reļ¬‚ected until several years after
the companyā™s ātrueā beta has changed.
9. The retention growth method is another method for estimating the growth rate
in dividends:
E(g) = Retention ratio Ć— E(ROE).
To illustrate the retention growth model, suppose Ann Arbor Health Systems
has had an average return on equity of about 14 percent over the past ten years.
The ROE has been relatively steady, but even so it has ranged from a low of
8.9 percent to a high of 17.6 percent during this period. In addition, the ļ¬rmā™s
dividend payout ratio has averaged 0.45 over the past ten years, so its retention
ratio has averaged 1.0 ā’ 0.45 = 0.55. Using these data, the retention growth
method gives an E(g) estimate of 7.7 percent:
E(g) = 0.55 Ć— 14% = 7.7%.
10. For one of the classic works on this topic, see Douglas A. Conrad, āReturns
on Equity to Not-For-Proļ¬t Hospitals: Theory and Implementation,ā Health
422 Healthcare Finance

Services Research, April 1984, 41ā“63. Also, see the follow-up articles by Pauly,
Conrad, and Silvers and Kauer in the April 1986 issue of Health Services Research.
11. For an excellent discussion of this position, see William O. Cleverley, āReturn on
Equity in the Hospital Industry: Requirement or Windfall?ā Inquiry (Summer
1982): 150ā“159.

References
Boles, K. E. 1986. āImplications of the Method of Capital Cost Payment on the
Weighted Average Cost of Capital.ā Health Services Research (June): 191ā“211.
. 1986. āWhat Accounting Leaves Out of Hospital Financial Management.ā
Hospital & Health Services Administration (March/April): 8ā“27.
Gapenski, L. C. 1993. āHospital Capital Structure Decisions: Theory and Practice.ā
Health Services Management Research (November): 237ā“247.
Harris, J. P., and V. E. Schimmel. 1987. āMarket Value: An Underused Financial
Planning Tool.ā Healthcare Financial Management (April): 40ā“46.
Messinger, S. F., and P. B. Stevenson. 1999. āPractice Financing Strategies Should
Match Investorsā™ Objectives.ā Healthcare Financial Management (May): 72ā“
76.
McCue, M. J., and Y. A. Ozcan. 1992. āDeterminants of Capital Structure.ā Hospital
& Health Services Administration (Fall): 333ā“346.
Sloan, F. A., J. Valvona, and M. Hassan. 1988. āCost of Capital to the Hospital
Sector.ā Journal of Health Economics (March): 25ā“45.
Smith, D. G., and J. R. C. Wheeler. 1989. āAccounting Based Risk Measures for
Not-for-Proļ¬t Hospitals.ā Health Services Management Research (November):
221ā“226.
Smith, D. G., J. R. C. Wheeler, H. L. Rivenson, and K. L. Reiter. 2000. āSources of
Project Financing in Health Care Systems.ā Journal of Health Care Finance
(Summer): 53ā“58.
Sterns, J. B., and T. K. Majidzadeh. 1995. āA Framework for Evaluating Capital
Structure.ā Journal of Health Care Finance (Winter): 80ā“85.
Valvona, J., and F. A. Sloan. 1988. āHospital Proļ¬tability and Capital Structure: A
Comparative Analysis.ā Health Services Research (August): 343ā“357.
Vaughan, J., and J. Wise. 1996. āHow to Choose the Right Capitalization Option.ā
Healthcare Financial Management (December): 72ā“74.
Wedig, G. J., M. Hassan, and M. A. Morrisey. 1996. āTax-Exempt Debt and the
Capital Structure of Nonproļ¬t Organizations: An Application to Hospitals.ā
Journal of Finance (September): 21ā“40.
Wedig, G. J., F. A. Sloan, M. Hassan, and M. A. Morrisey. 1988. āCapital Structure,
Ownership, and Capital Payment Policy: The Case of Hospitals.ā Journal of
Finance (March): 21ā“40.
Wheeler, J. R. C., and D. G. Smith. 1988. āThe Discount Rate for Capital Expenditure
Analysis in Health Care.ā Health Care Management Review (Spring): 43ā“51.
Wheeler, J. R. C., D. G. Smith, H. L. Rivenson, and K. L. Reiter. 2000. āCapital
Structure Strategy in Health Care Systems.ā Journal of Health Care Finance
(Summer): 42ā“52.
PAR T

VI
Capital Investment Decisions
CHAP TER

14
THE BASICS OF
CAPITAL BUDGETING

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

ā¢ Explain how managers use project classiļ¬cations and post-audits in
the capital budgeting process.
ā¢ Discuss the role of ļ¬nancial analysis in health services capital
budgeting decisions.
ā¢ Discuss the key elements of cash ļ¬‚ow estimation, breakeven
analysis, and proļ¬tability analysis.
ā¢ Conduct basic capital budgeting analyses.

Introduction
Chapter 13 described how health services managers make capital structure
decisions and estimate their businessā™s corporate cost of capital. The focus of
this chapter is ļ¬xed asset acquisition decisions, which involve the expenditure
of capital funds. Thus, decisions of this type are called capital investment, or
capital budgeting, decisions. Capital budgeting decisions are of fundamental
importance to the success or failure of any business because a ļ¬rmā™s capital
budgeting decisions, more than anything else, shape its future.
The discussion of capital budgeting is divided into two chapters. Chap-
ter 14 provides an overview of the capital budgeting process, a discussion of
the key elements of project cash ļ¬‚ow estimation, and an explanation of the ba-
sic techniques used to assess a projectā™s breakeven and proļ¬tability. In Chapter
15, we focus on capital budgeting risk analysis and incorporation.

Importance of Capital Budgeting
Capital budgeting decisions are among the most critical decisions that health
services managers must make. First and most importantly, the results of capital
budgeting decisions generally affect the business for an extended period. If a
business invests too heavily in ļ¬xed assets, it will have too much capacity and
its costs will necessarily be too high. On the other hand, a business that invests
too little in ļ¬xed assets may face two problems: technological obsolescence and
425
426 Healthcare Finance

inadequate capacity. A healthcare provider without the latest in technology
will lose patients to its more up-to-date competitors and, further, will deprive
its patients of the best healthcare diagnostics and treatments available.
Effective capital budgeting procedures provide several beneļ¬ts to busi-
nesses. A business that forecasts its needs for capital assets well in advance
will have the opportunity to plan the acquisitions carefully, and thus will be
able to negotiate the highest quality assets at the best prices. Additionally,
asset expansion typically involves substantial expenditures, and because large
amounts of funds are not usually at hand, they must be raised externally. Good
capital budgeting practices permit a business to identify its ļ¬nancing needs and
sources well in advance, which ensures both the lowest possible procurement
costs and the availability of funds as they are needed.

Self-Test 1. Why are capital budgeting decisions so crucial to the success of a
2. What are the beneļ¬ts of effective capital budgeting procedures?

Project Classiļ¬cations
Although beneļ¬ts can be gained from the careful analysis of capital investment
proposals, such efforts can be costly. For certain projects, a relatively detailed
analysis may be warranted along with senior management involvement; for
others, simpler procedures should be used. Accordingly, healthcare businesses
generally classify projects into categories, and by cost within each category,
and then analyze each project on the basis of its category and cost. For
example, Bayside Memorial Hospital uses the following classiļ¬cations:

ā¢ Category 1: Mandatory replacement. Category 1 consists of
expenditures necessary to replace worn-out or damaged equipment
necessary to the operations of the hospital. In general, these expenditures
are mandatory, so they are usually made with only very limited analyses
and decision processes.
ā¢ Category 2: Discretionary replacement. This category includes
expenditures to replace serviceable but obsolete equipment. The purpose
of these projects generally is to lower costs or to provide more clinically
effective services. Because Category 2 projects are not mandatory, a more
detailed decision process is generally required to support the expenditure
than that needed for Category 1 projects.
ā¢ Category 3: Expansion of existing services or markets. Expenditures
to increase capacity, or to expand within markets currently being served by
the hospital, are included here. These decisions are more complex, so still
more detailed analysis is required, and the ļ¬nal decision is made at a
higher level within the organization.
427
Chapter 14: The Basics of Capital Budgeting

ā¢ Category 4: Expansion into new services or markets. These are projects
necessary to provide new services or to expand into geographical areas not
currently being served. Such projects involve strategic decisions that could
change the fundamental nature of the hospital, and they normally require
the expenditure of large sums of money over long periods. Invariably, a
particularly detailed analysis is required, and the board of trustees
generally makes the ļ¬nal decision as part of the hospitalā™s strategic plan.
ā¢ Category 5: Environmental projects. This category consists of
expenditures necessary to comply with government orders, labor
agreements, accreditation requirements, and so on. Unless the
expenditures are large, Category 5 expenditures are treated like Category
1 expenditures.
ā¢ Category 6: Other. This category is a catchall for projects that do not ļ¬t
neatly into another category. The primary determinant of how Category 6
projects are evaluated is the amount of funds required.

Self-Test
1. What is the advantage of classifying capital projects?
Questions
2. What are some typical classiļ¬cations?

The Role of Financial Analysis in Healthcare
Capital Budgeting
For investor-owned businesses, with shareholder wealth maximization as the
primary goal, the role of ļ¬nancial analysis in capital investment decisions is
clear. Those projects that contribute to shareholder wealth should be under-
taken, while those that do not should be ignored. However, what about not-
for-proļ¬t ļ¬rms, which do not have shareholder wealth maximization as a goal?
In such ļ¬rms, the appropriate goal is providing quality, cost-effective service to
the communities served. (A strong argument could be made that this should
also be the goal of investor-owned businesses in the health services industry.)
In this situation, capital budgeting decisions must consider many factors be-
sides a projectā™s ļ¬nancial implications. For example, the needs of the medical
staff and the good of the community must be taken into account. Indeed, in
many instances, noneconomic factors will outweigh ļ¬nancial considerations.
Nevertheless, good decision making, and hence the future viability of
healthcare businesses, requires that the ļ¬nancial impact of capital investments
be fully recognized. If a business takes on a series of highly unproļ¬table
projects that meet nonļ¬nancial goals, and such projects are not offset by
proļ¬table ones, the ļ¬rmā™s ļ¬nancial condition will deteriorate. If this situation
persists over time, the business will eventually lose its ļ¬nancial viability and
could even be forced into bankruptcy and closure.1
Because bankrupt ļ¬rms cannot meet a communityā™s needs, even man-
agers of not-for-proļ¬t businesses must consider a projectā™s potential impact
428 Healthcare Finance

on the ļ¬rmā™s ļ¬nancial condition. Managers may make a conscious decision
to accept a project with a poor ļ¬nancial prognosis because of its nonļ¬nancial
virtues, but it is important that managers know the ļ¬nancial impact up front,
rather than be surprised when the project drains the ļ¬rmā™s ļ¬nancial resources.
Financial analysis provides managers with the relevant information about a
projectā™s ļ¬nancial impact and hence helps managers make better decisions,
including those decisions based primarily on nonļ¬nancial considerations.

Self-Test 1. What is the role of ļ¬nancial analysis in capital budgeting decision making
Questions within for-proļ¬t ļ¬rms?
2. Why is project ļ¬nancial analysis important in not-for-proļ¬t businesses?

Overview of Capital Budgeting Financial Analysis
The ļ¬nancial analysis of capital investment proposals typically involves the
following ļ¬ve steps:

1. The capital outlay, or cost of the project, must be estimated.
2. The operating and terminal cash ļ¬‚ows of the project must be forecasted.
Steps 1 and 2 constitute the cash ļ¬‚ow estimation phase, which is discussed
in the next section.
3. The riskiness of the estimated cash ļ¬‚ows must be assessed. Project risk
assessment will be discussed in Chapter 15.
4. Given its riskiness, the project cost of capital is estimated. As we discussed
in Chapter 13, the ļ¬rmā™s corporate (or divisional) cost of capital reļ¬‚ects
the average risk of the ļ¬rmā™s (or divisionā™s) assets. If the project being
evaluated does not have average risk, the cost of capital must be adjusted.
5. Finally, the ļ¬nancial attractiveness of the project is assessed. Several
measures can be used for this purpose, including both breakeven and
proļ¬tability measures.

Self-Test 1. Explain the ļ¬ve steps in capital budgeting ļ¬nancial analysis.
Question

Cash Flow Estimation
The most critical and most difļ¬cult step in evaluating capital investment pro-
posals is cash ļ¬‚ow estimation. This step involves estimating the investment
outlays, the annual net operating ļ¬‚ows expected when the project goes into
operation, and the cash ļ¬‚ows associated with project termination. Many vari-
ables are involved in cash ļ¬‚ow estimation, and many individuals and depart-
ments participate in the process. Making accurate projections of the costs and
revenues associated with a large, complex project is difļ¬cult, so forecast errors
429
Chapter 14: The Basics of Capital Budgeting

can be quite large.2 Thus, it is essential that risk analyses be performed on
prospective projects.
Neither the difļ¬culty nor the importance of cash ļ¬‚ow estimation can
be overstated. However, if the principles discussed in the next section are
observed, errors that often arise in the next sections can be minimized.

Incremental Cash Flows
The relevant cash ļ¬‚ows to consider when evaluating a new capital investment
are the projectā™s incremental cash ļ¬‚ows, which are deļ¬ned as the ļ¬rmā™s cash
ļ¬‚ows in each period if the project is undertaken minus the ļ¬rmā™s cash ļ¬‚ows if
the project is not undertaken:

Incremental CFt = CFt(Firm with project) ā’ CFt(Firm without project) .

Here the subscript t speciļ¬es a time periodā”often years. CF0 is the incremen-
tal cash ļ¬‚ow during Year 0, which is generally assumed to end when the ļ¬rst
cash ļ¬‚ow occurs; CF1 is the incremental cash ļ¬‚ow during the ļ¬rst year; CF2
is the incremental cash ļ¬‚ow during Year 2; and so on. In practice, the early
incremental cash ļ¬‚ows, and Year 0 in particular, are usually cash outļ¬‚owsā”the
costs associated with getting the project up and running. As the project begins
to generate revenues, the incremental cash ļ¬‚ows normally turn positive.
In practice, it typically is not feasible to forecast the cash ļ¬‚ows of a
business with and without a new project. Thus, the actual estimation process
focuses on the cash ļ¬‚ows unique to the project being evaluated. However,
if a doubt ever arises whether or not a particular cash ļ¬‚ow is relevant to the
analysis, it is often useful to fall back on the basic deļ¬nition given above.

Cash Flow Versus Accounting Income
As discussed in Chapters 3 and 4, accounting income statements deļ¬ne rev-
enues and costs in terms that do not reļ¬‚ect the actual movement of cash. In
capital investment decisions, the decision must be based on the actual dollars
that ļ¬‚ow into and out of the business. A ļ¬rmā™s true proļ¬tability, and hence
its future ļ¬nancial condition, depends more on its cash ļ¬‚ows than on income
as reported in accordance with GAAP.

Cash Flow Timing
Financial analysts must be careful to account properly for the timing of cash
ļ¬‚ows. Accounting income statements are for periods such as years or quarters,
so they do not reļ¬‚ect exactly when, during the period, revenues and expenses
occur. In theory, capital budgeting cash ļ¬‚ows should be analyzed exactly as
they are expected to occur. Of course, there must be a compromise between
accuracy and simplicity. A time line with daily cash ļ¬‚ows would in theory
provide the most accuracy, but daily cash ļ¬‚ow estimates would be costly to
construct, unwieldy to use, and probably no more accurate than annual cash
ļ¬‚ow estimates. Thus, in most cases, analysts simply assume that all cash ļ¬‚ows
430 Healthcare Finance

occur at the end of each year. However, for some projects, it may be useful
to assume that cash ļ¬‚ows occur every six months or to forecast quarterly or
monthly cash ļ¬‚ows.

Project Life
Perhaps the ļ¬rst decision that must be made in forecasting a projectā™s cash
ļ¬‚ows is the life of the project. Does the forecast for cash ļ¬‚ows need to be for 20
years or is ļ¬ve years sufļ¬cient? Many projects, such as a new hospital wing or an
ambulatory care clinic, have very long productive lives. In theory, a cash ļ¬‚ow
forecast should extend for the full life of a project, yet most managers would
have very little conļ¬dence in any cash ļ¬‚ow forecasts beyond the near term.
Thus, most organizations set an arbitrary limit on the project life assumed in
capital budgeting analysesā”often ļ¬ve or ten years. If the forecasted life is less
than the arbitrary limit, the forecasted life is used to develop the cash ļ¬‚ows,
but if the forecasted life exceeds the limit, project life is truncated and the
operating cash ļ¬‚ows beyond the limit are ignored.
Although cash ļ¬‚ow truncation is a practical solution to a difļ¬cult prob-
lem, it does create another problem; the value inherent in the cash ļ¬‚ows be-
yond the truncation point is lost to the project. This problem can be addressed
either objectively or subjectively. The standard procedure at some organiza-
tions is to estimate the projectā™s terminal value, which is the estimated value
of the cash ļ¬‚ows beyond the truncation point. Sometimes, the terminal value
is estimated as the liquidation value of the project at that point in time. If
the terminal value is too difļ¬cult to estimate, the fact that some portion of
the projectā™s cash ļ¬‚ow value is being ignored should, at a minimum, be sub-
jectively recognized by decision makers. The saving grace in all of this is that
cash ļ¬‚ows forecasted to occur well into the future typically contribute a rel-
atively small amount to a projectā™s initial proļ¬tability estimate. For example,
a \$100,000 terminal value projected ten years in the future contributes only
about \$38,500 to the projectā™s value when the project cost of capital (discount
rate) is 10 percent.
Some projects have short lives, and hence the analysis can extend over
the projectā™s entire life. In such situations, the assets associated with the project
may still have some value remaining when the project is terminated. The cash
ļ¬‚ow expected to be realized from selling the projectā™s assets at termination
is called salvage value. Even if a project is being terminated for āold age,ā
any cash ļ¬‚ow that will arise by virtue of scrap value must be included in the
projectā™s cash ļ¬‚ows. For investor-owned businesses, such asset sales typically
will trigger tax consequences, which are discussed in the cash ļ¬‚ow estimation
example presented in the next major section.

Sunk Costs
A sunk cost refers to an outlay that has already occurred or has been irrevocably
committed, so it is an outlay that is unaffected by the current decision to
431
Chapter 14: The Basics of Capital Budgeting

accept or reject a project. To illustrate, suppose that in 2005 Bayside Memorial
Hospital is evaluating the purchase of a lithotripter system. To help in the
decision, the hospital hired and paid \$10,000 to a consultant in 2004 to
conduct a marketing study. This cash ļ¬‚ow is not relevant (nonincremental ) to
the capital investment decision; Bayside cannot recover it whether or not the
lithotripter is purchased. Sometimes a project appears to be unproļ¬table when
all of its associated costs, including sunk costs, are considered. However, on
an incremental basis, the project may be proļ¬table and should be undertaken.
Thus, the correct treatment of sunk costs may be critical to the decision.

Opportunity Costs
All relevant opportunity costs must be included in a capital investment analysis.
To illustrate, one opportunity cost involves the use of the funds required
to ļ¬nance the project. If the ļ¬rm uses its capital to invest in Project A, it
cannot use the capital to invest in Project B, or for any other purpose. The
opportunity cost associated with capital use is accounted for in the project
cost of capital, which represents the return that the business could earn by
investing in alternative investments of similar risk. The mathematics of the
discounting process forces the opportunity cost of capital to be considered in
the analysis.
In addition to the opportunity cost of capital, there are other types
of opportunity costs that arise in capital budgeting analyses. For example,
assume that Baysideā™s lithotripter would be installed in a freestanding facility
and that the hospital currently owns the land on which the facility would be
constructed. In fact, the hospital purchased the land ten years ago at a cost
of \$50,000, but the current market value of the property is \$130,000, after
subtracting both legal and real estate fees. When evaluating the lithotripter,
the value of the land cannot be disregarded merely because no cash outlay is
necessary. There is an opportunity cost inherent in the use of the property
because using the property for the lithotripter facility deprives Bayside of its
use for other purposes. The property might be used for a walk-in clinic or
ambulatory surgery center or parking garage rather than sold, but the best
measure of its value to Bayside, and hence the opportunity cost inherent in its
use, is the cash ļ¬‚ow that could be realized from selling the property.
By considering the propertyā™s current market value, Bayside is letting
market forces assign the value for the landā™s best alternative use. Thus, the
lithotripter project should have a \$130,000 opportunity cost charged against
it. The opportunity cost is the propertyā™s \$130,000 net market value, irre-
spective of whether the property was acquired for \$50,000 or \$200,000.

Capital budgeting analyses must consider the effects of the project under
consideration on the ļ¬rmā™s existing business lines. Such effects can be either
positive or negative; when negative, it is often called cannibalization. To
432 Healthcare Finance

illustrate, assume that some of the patients that are expected to use Baysideā™s
new lithotripter would have been treated surgically at Bayside, so these surgical
revenues will be lost if the lithotripter facility goes into operation. Thus, the
incremental cash ļ¬‚ows to Bayside are the ļ¬‚ows attributable to the lithotripter,
less those lost from forgone surgery services.
On the other hand, new patients that use the lithotripter may utilize
ancillary services provided by the hospital. In this situation, the incremental
cash ļ¬‚ows generated by the lithotripter patientsā™ utilization of other services
should be credited to the lithotripter project. If possible, both positive and
negative effects on other projects should be quantiļ¬ed, but at a minimum
they should be noted, so that these effects are subjectively considered when
the ļ¬nal decision regarding the project is made.

Shipping, Installation, and Related Costs
When a business acquires ļ¬xed assets, it often incurs substantial costs for
shipping and installing the equipment or for other related activities. These
charges must be added to the invoice price of the equipment to determine the
overall cost of the project. Also, the full cost of the equipment, including such
costs, typically is used as the basis for calculating depreciation charges. Thus,
if Bayside Memorial Hospital purchases intensive care monitoring equipment
that costs \$800,000, but another \$200,000 is required for shipping and
installation, the full cost of the equipment would be \$1 million, and this
amount would be the starting point for both tax (when applicable) and book
depreciation calculations.

Changes in Net Working Capital
Normally, expansion projects require additional inventories, and expanded
these current assets must be ļ¬nanced, just as an increase in ļ¬xed assets must
be ļ¬nanced. (Increases on the asset side of the balance sheet must be offset
by matching increases on the liabilities and equity side.) However, accounts
payable and accruals will probably also increase as a result of the expansion,
and these current liability funds will reduce the net cash needed to ļ¬nance the
increase in inventories and receivables.
Current assets are often referred to as working capital, and the differ-
ence between current assets and current liabilities is called net working capital.
Thus, projects that have an impact on current assets and current liabilities cre-
ate changes in net working capital. If this change is positive (i.e., if the increase
in current assets exceeds the increase in current liabilities), this amount is as
much a cash cost to the project as is the dollar cost of the asset itself. Such
projects must be charged an additional amount above the dollar cost of the
new ļ¬xed asset to reļ¬‚ect the net ļ¬nancing needed for current asset accounts.
Similarly, if the change in net working capital is negative, the project is gen-
erating a positive working capital cash ļ¬‚ow because the increase in liabilities
433
Chapter 14: The Basics of Capital Budgeting

exceeds the projectā™s current asset requirements, and this cash ļ¬‚ow partially
offsets the cost of the asset being acquired.
As the project approaches termination, inventories will be sold off and
not replaced, and receivables will be converted to cash without new receivables
being created. In effect, the business will recover its investment in net working
capital when the project is terminated. This will result in a cash ļ¬‚ow that is
equal but opposite in sign to the change in net working capital cash ļ¬‚ow that
arises at the beginning of a project.
For healthcare providers, where inventories often represent a very small
part of the investment in new projects, the change in net working capital
often can be ignored without materially affecting the results of the analysis.
However, when a project requires a large positive change in net working
capital, failure to consider the net investment in current assets will result in an
overstatement of the projectā™s proļ¬tability.

Inļ¬‚ation Effects
Because inļ¬‚ation effects can have a considerable inļ¬‚uence on a projectā™s prof-
itability, inļ¬‚ation must be considered in any sound capital budgeting analysis.
As we discussed in Chapter 13, a ļ¬rmā™s corporate cost of capital is a weighted
average of its costs of debt and equity. These costs are estimated on the basis
of investorsā™ required rates of return, and investors incorporate an inļ¬‚ation
premium into such estimates. For example, a debt investor might require a
5 percent return on a ten-year bond in the absence of inļ¬‚ation. However,
if inļ¬‚ation is expected to average 4 percent over the coming ten years, the
investor would require a 9 percent return. Thus, investors add an inļ¬‚ation
loss of purchasing power that stems from inļ¬‚ation.
Because inļ¬‚ation effects are already imbedded in the corporate cost of
capital, and because this cost will be used as the starting point to discount
the cash ļ¬‚ows in the proļ¬tability measures, inļ¬‚ation effects must also be built
into the projectā™s estimated cash ļ¬‚ows. If cash ļ¬‚ow estimates do not include
inļ¬‚ation effects, but a discount rate is used that includes inļ¬‚ation effects, the
proļ¬tability of the project will be understated.
The most effective way to deal with inļ¬‚ation is to apply inļ¬‚ation effects
to each cash ļ¬‚ow component using the best available information about how
each component will be affected. Because it is impossible to estimate future
inļ¬‚ation rates with much precision, errors will probably be made. Often,
inļ¬‚ation is assumed to be neutral (i.e., it is assumed to affect all revenue
and cost components, except depreciation, equally). However, it is common
for costs to be rising faster than revenues or vice versa. Thus, in general, it
is better to apply different inļ¬‚ation rates to each cash ļ¬‚ow component. For
example, net revenues might be expected to increase at a 3 percent rate, while
labor costs might be expected to increase at a 5 percent rate. Inļ¬‚ation adds to
the uncertainty, and hence risk, of a project under consideration as well as to
434 Healthcare Finance

the complexity of the capital budgeting analysis. Fortunately, computers and
spreadsheet programs can easily handle the mechanics of inļ¬‚ation analysis.

Strategic Value
Sometimes, a project will have value in addition to that inherent in its cash
ļ¬‚ows. A major source of hidden value, called strategic value, stems from future
investment opportunities that can be undertaken only if the project currently
under consideration is accepted.
To illustrate this concept, consider a hospital management company
that is analyzing a management contract for a hospital in Hungary, which
is its ļ¬rst move into Eastern Europe. On a stand-alone basis, this project
might be unproļ¬table, but the project might provide entry into the Eastern
European market, which could unlock the door to a whole range of highly
proļ¬table new projects. Or consider Bayside Memorial Hospitalā™s decision to
start a kidney transplant program. The ļ¬nancial analysis of this project showed
the program to be unproļ¬table, but Baysideā™s managers considered kidney
transplants to be the ļ¬rst step in an aggressive transplant program that would
not only be proļ¬table in itself but would enhance the hospitalā™s reputation
for technological and clinical excellence and thus would contribute to the
hospitalā™s overall proļ¬tability.
In theory, the best approach to dealing with strategic value is to fore-
cast the cash ļ¬‚ows from the follow-on projects, estimate their probabilities of
occurrence, and then add the expected cash ļ¬‚ows from the follow-on projects
to the cash ļ¬‚ows of the project under consideration. In practice, this is usually
impossible to doā”either the follow-on cash ļ¬‚ows are too nebulous to fore-
cast or the potential follow-on projects are too numerous to quantify.3 At a
minimum, decision makers must recognize that some projects have strategic
value, and this value should be qualitatively considered when making capital
budgeting decisions.

Self-Test 1. Brieļ¬‚y discuss the following concepts associated with cash ļ¬‚ow estima-
Questions tion:
ā¢ Incremental cash ļ¬‚ow
ā¢ Cash ļ¬‚ow versus accounting income
ā¢ Cash ļ¬‚ow timing
ā¢ Project life
ā¢ Terminal value
ā¢ Salvage value
ā¢ Sunk costs
ā¢ Opportunity costs
ā¢ Effects on current business lines
435
Chapter 14: The Basics of Capital Budgeting

ā¢ Shipping and installation costs
ā¢ Changes in net working capital
ā¢ Inļ¬‚ation effects
ā¢ Strategic value
2. Evaluate the following statement: Ignoring inļ¬‚ation effects and strate-
gic value can result in overstating a projectā™s ļ¬nancial attractiveness.

Cash Flow Estimation Example
Up to this point, several critical aspects of cash ļ¬‚ow estimation have been
discussed. In this section, we illustrate some of the concepts already covered
and introduce several others that are important to good cash ļ¬‚ow estimation.

The Basic Data
Consider the situation faced by Bayside Memorial Hospital in its evaluation
of a new MRI system. The system costs \$1.5 million, and the not-for-proļ¬t
hospital would have to spend another \$1 million for site preparation and
installation. Because the system would be installed in the hospital, the space
to be used has a very low, or zero, market value to outsiders. Furthermore,
its value to Bayside for other projects is very difļ¬cult to estimate, so no
opportunity cost has been assigned to account for the value of the site.
The MRI system is estimated to have weekly utilization (i.e., volume)
of 40 scans, and each scan on average would cost the hospital \$15 in supplies.
The system is expected to be operated 50 weeks a year, with the remaining
two weeks devoted to maintenance. The estimated average charge per scan
is \$500, but 25 percent of this amount, on average, is expected to be lost to
indigent patients, contractual allowances, and bad debt losses. Baysideā™s man-
agers developed the projectā™s forecasted revenues by conducting the revenue
analysis contained in Table 14.1.
The MRI system would require two technicians, resulting in an incre-
mental increase in annual labor costs of \$50,000, including fringe beneļ¬ts.
Cash overhead costs would increase by \$10,000 annually if the MRI is acti-
vated. The equipment would require maintenance, which would be furnished
by the manufacturer for an annual fee of \$150,000, payable at the end of each
year of operation. For book purposes, the MRI will be depreciated by the
straight-line method over a ļ¬ve-year life.
The MRI system is expected to be in operation for ļ¬ve years, at which
time the hospitalā™s master plan calls for a new imaging facility. The hospital
plans to sell the MRI at that time for an estimated \$750,000 salvage value,
net of removal costs. The inļ¬‚ation rate is estimated to average 5 percent
over the period, and this rate is expected to affect all revenues and costs
except depreciation. Baysideā™s managers initially assume that projects under
evaluation have average risk, and thus the hospitalā™s 10 percent corporate cost
436 Healthcare Finance

TABLE 14.1
Number
Bayside of Scans Charge Total Basis of Net Payment Total
Payer per Week per Scan Charges Payment per Scan Payments
Memorial
Hospital: MRI
System Revenue Medicare 10 \$500 \$ 5,000 Fixed fee \$370 \$ 3,700
Medicaid 5 500 2,500 Fixed fee 350 1,750
Analysis
Private insurance 9 500 4,500 Full charge 500 4,500
Blue Cross 5 500 2,500 Percent of charge 420 2,100
Managed care 7 500 3,500 Percent of charge 390 2,730
Self-pay 4 500 2,000 Full charge 55 220

Total 40 \$20,000 \$15,000

Average \$ 500 \$ 375

of capital is the appropriate project cost of capital (opportunity cost discount
rate). In Chapter 15, a risk assessment of the project may indicate that a
different cost of capital is appropriate.
Although the MRI project is expected to take away some patients from
the hospitalā™s other imaging systems, the new MRI patients are expected to
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