. 20
( 21)


(in thousands)

Cash and cash equivalents $ 2,737
Net premiums receivable 821
Supplies 387
Total current assets $ 3,945
Net property and equipment $ 5,924
Total assets $ 9,869

Liabilities and Net Assets
Accounts payable“medical services $ 2,145
Accrued expenses 929
Notes payable 141
Current portion of long-term debt 241
Total current liabilities $ 3,456
Long-term debt $ 4,295
Total liabilities $ 7,751
Net assets (equity) $ 2,118

Total liabilities and net assets $ 9,869

a. Perform a Du Pont analysis on BestCare. Assume that the industry
average ratios are as follows:
Total margin 3.8%
Total asset turnover 2.1
Equity multiplier 3.2
Return on equity (ROE) 25.5%
b. Calculate and interpret the following ratios for BestCare:
Industry Average
Return on assets (ROA) 8.0%
Current ratio 1.3
Days cash on hand 41days
Average collection period 7days
Debt ratio 69%
Debt-to-equity ratio 2.2
Times interest earned (TIE) ratio 2.8
Fixed asset turnover ratio 5.2
Chapter 17: Analyzing Financial Performance

17.5 Consider the following ¬nancial statements for Green Valley Nursing
Home, Inc., a for-pro¬t, long-term care facility:

Green Valley Nursing Home, Inc.
Statement of Income and Retained Earnings
Year Ended December 31, 2004

Net patient service revenue $ 3,163,258
Other revenue 106,146
Total revenues $ 3,269,404
Salaries and bene¬ts $ 1,515,438
Medical supplies and drugs 966,781
Insurance and other 296,357
Provision for bad debts 110,000
Depreciation 85,000
Interest 206,780
Total expenses $ 3,180,356
Operating income $ 89,048
Provision for income taxes 31,167

Net income $ 57,881

Retained earnings, beginning of year $ 199,961

Retained earnings, end of year $ 257,842

Green Valley Nursing Home, Inc.
Balance Sheet
December 31, 2004

Current Assets:
Cash $ 105,737
Marketable securities 200,000
Net patient accounts receivable 215,600
Supplies 87,655
Total current assets $ 608,992
Property and equipment $ 2,250,000
Less accumulated depreciation 356,000
Net property and equipment $ 1,894,000

Total assets $ 2,502,992

Liabilities and Shareholders™ Equity
Current Liabilities:
Accounts payable $ 72,250
558 Healthcare Finance

Accrued expenses 192,900
Notes payable 100,000
Current portion of long-term debt 80,000
Total current liabilities $ 445,150
Long-term debt $ 1,700,000
Shareholders™ Equity:
Common stock, $10 par value $ 100,000
Retained earnings 257,842
Total shareholders™ equity $ 357,842

Total liabilities and shareholders™ equity $ 2,502,992

a. Perform a Du Pont analysis on Green Valley. Assume that the
industry average ratios are as follows:
Total margin 3.5%
Total asset turnover 1.5
Equity multiplier 2.5
Return on equity (ROE) 13.1%

b. Calculate and interpret the following ratios:
Industry Average
Return on assets (ROA) 5.2%
Current ratio 2.0
Days cash on hand 22 days
Average collection period 19 days
Debt ratio 71 %
Debt-to-equity ratio 2.5
Times interest earned (TIE) ratio 2.6
Fixed asset turnover ratio 1.4

c. Assume that there are 10,000 shares of Green Valley™s stock
outstanding and that some recently sold for $45 per share.
• What is the ¬rm™s price/earnings ratio?
• What is its market/book ratio?
17.6 Examine the industry average ratios given in Problems 17.4 and 17.5
above. Explain why the ratios are different between the managed care
and nursing home industries?

1. Industry average ratios are available from many sources. For example, Ingenix
publishes an annual almanac that provides hospital indusrty data on 33
¬nancial ratios and 43 operating indicator ratios. The ratios are reported
in several groupings, such as by hospital size and geographic location. See
www.hospitalbenchmarks.com. The industry average ratios presented in this
chapter are for illustrative use only and hence should not be used for making
Chapter 17: Analyzing Financial Performance

real-world comparisons. Also, note that in accordance with standard practice,
we are calling the comparative data averages, but in reality they are median
values. Median values are better for comparisons because they are not biased by
extremely high or low values in the industry data set.
2. To determine the minimum proportional value that must be obtained from
current assets to meet current obligations, divide the number 1 by the current
ratio. For Riverside, 1 / 2.3 = 0.43, or 43%. If liquidated at 43 cents on the
dollar, the hospital™s current assets would provide 0.43 — $31,280,000 ≈
$13,332,000 in cash, which equals the amount of current liabilities.
3. Riverside™s 2004 current asset turnover ratio (total revenues divided by total
current assets) was 3.8, compared to an industry average of 3.6, so the hospital
is slightly above average regarding current asset utilization.
4. Because information on credit sales is generally unavailable, total patient services
revenue must be used. Although almost all hospital services are provided on
credit because of the third-party-payer system, other healthcare businesses
may not have the same high percentage of credit sales. As the proportion of
cash sales increases, the days in patient accounts receivable measure loses its
usefulness. Also, it would be better to use average receivables in the ratio,
either calculated as an average of monthly ¬gures or as (Beginning receivables +
Ending receivables) / 2.
5. For pedagogic reasons, we discussed ratio analysis before Du Pont analysis.
However, when actually conducting a ¬nancial performance analysis, most
analysts would conduct the Du Pont analysis ¬rst. The idea here is to use Du
Pont analysis to gain an overview of the business™s ¬nancial condition. Then,
with some understanding of the business™s ¬nancial strengths and weaknesses,
the ratio analysis can focus on those areas identi¬ed as critical to improving
6. For more information on common size and percentage change analysis, see L. C.
Gapenski, Understanding Healthcare Financial Management (Chicago: Health
Administration Press, 2003), Chapter 13.
7. For an excellent example of the application of EVA in setting managerial
compensation within not-for-pro¬t ¬rms, see W. O. Cleverley and R. K.
Harvey, “Economic Value Added”A Framework for Health Care Executive
Compensation,” Hospital & Health Services Administration (Summer 1993):
8. The EVA concept was ¬rst developed in detail by the consulting ¬rm of Stern
Stewart Management Services. For a more complete discussion, see G. B.
Stewart, III, The Quest for Value (New York: HarperBusiness, 1991).

Beaver, W. H., and J. E. Horngren. 1991. “Ten Commandants of Financial Statement
Analysis.” Financial Analysts Journal (January“February): 9.
Boles, K. E. 1992. “Insolvency in Managed Care Organizations: Financial Indicators.”
Topics in Health Care Financing (Winter): 40“57.
Cleverley, W. O., and R. K. Harvey. 1990. “Pro¬tability: Comparing Hospital Results
with Other Industries.” Healthcare Financial Management (March): 42“52.
560 Healthcare Finance

. 1994. “Trends in the Hospital Financial Picture.” Healthcare Financial Man-
agement (February): 56“63.
. 1995. “Understanding Your Hospital™s True Financial Position and Chang-
ing It.” Health Care Management Review (Spring): 62“73.
Coyne, J. S. 1985. “Measuring Hospital Performance in Multi-Institutional Orga-
nizations Using Financial Ratios.” Health Care Management Review (Fall):
. 1990. “Analyzing the Financial Performance of Hospital-Based Managed
Care Programs: The Case of Humana.” Journal of Health Administration
Education (Fall): 571“642.
Eastaugh, S. R. 1992. “Hospital Strategy and Financial Performance.” Health Care
Management Review (Summer): 19“32.
Finkler, S. A. 1982. “Ratio Analysis: Use with Caution.” Health Care Management
Review (Spring): 65“72.
Harkey, J., and R. Vraciu. 1992. “Quality of Health Care and Financial Performance:
Is There a Link?” Health Care Management Review (Fall): 55“61.
Lynn, M. L., and P. Wertheim. 1993. “Key Financial Ratios Can Foretell Hospital
Closures.” Healthcare Financial Management (November): 66“70.
McCue, M. J. 1991. “The Use of Cash Flow to Analyze Financial Distress in California
Hospitals.” Hospital & Health Services Administration (Summer): 223“241.
Pink, G. H., et al. 2001. “Creating a Balanced Scorecard For a Hospital System.”
Journal of Healthcare Finance (Spring): 1“20.
Prince, T. R. 1991. “Assessing Financial Outcomes of Not-for-Pro¬t Community
Hospitals.” Hospital & Healthcare Administration (Fall): 331“349.
Sherman, B. 1990. “How Investors Evaluate the Creditworthiness of Hospitals.”
Healthcare Financial Management (March): 25“31.
Sylvestre, J., and F. R. Urbancic. 1994. “Effective Methods for Cash Flow Analysis.”
Healthcare Financial Management (July): 62“72.
Watkins, A. L. 2003. “A Balanced Perspective: Using Non¬nancial Measures to Assess
Financial Performance.” Healthcare Financial Management (November): 76“
Wyatt, J. 2004. “Scoreboards, Dashboards, and KPIs: Keys to Integrated Performance
Measurement.” Healthcare Financial Management (February): 76“80.
Zeller, T. L., B. B. Stanko, and W. O. Cleverley. 1997. “A New Perspective on Hospital
Financial Ratio Analysis.” Healthcare Financial Management (November):


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

• Describe the two primary types of leases.
• Explain how lease ¬nancing affects both ¬nancial statements and
• Conduct a basic lease analysis from the perspective of the lessee.
• Discuss the factors that create value in lease transactions.
• Explain in general terms how businesses are valued.
• Conduct a business valuation using both discounted cash ¬‚ow and
market multiple approaches.

This chapter contains two unrelated topics: lease ¬nancing and business valu-
ation. Leasing is a substitute for debt ¬nancing and hence expands the range
of ¬nancing alternatives available to businesses (and to individuals). However,
leasing should be used only when it offers some advantage over conventional
¬nancing. We begin this chapter by discussing how businesses analyze lease
transactions and what factors contribute to the large amount of leasing activity
among healthcare businesses.
The valuation of entire businesses, as opposed to capital projects, is
a critical step in the merger and acquisition process. In addition, business
valuation plays an important role when one owner is bought out by other
owners and when businesses are inherited. The second part of this chapter
discusses two speci¬c techniques used to value businesses.

Leasing Basics
Businesses generally own ¬xed assets, but it is the use of buildings and equip-
ment that is important, not their ownership. One way to obtain the use of
assets is to raise debt or equity capital, and then use this capital to buy them.
An alternative way to obtain the use of assets is by leasing. Prior to the 1950s,
leasing was generally associated with real estate (land and buildings), but today
562 Healthcare Finance

it is possible to lease almost any kind of asset. Although leasing is used exten-
sively across all industries, it is especially prevalent in the health services indus-
try, primarily with medical equipment and information technology hardware
and software.1
Note that every lease transaction has two parties: The user of the
leased asset is called the lessee, while the owner of the property, usually the
manufacturer or a leasing company, is called the lessor. (The term “lessee” is
pronounced “less-ee,” not “lease-ee,” and “lessor” is pronounced “less-or.”)
Leases are commonly classi¬ed into two categories: operating leases and
¬nancial leases. In this section, we discuss these informal classi¬cations. In later
sections, we will discuss the more formal classi¬cations used by accountants
and by the IRS.

Operating Leases
Operating leases, sometimes called service leases, generally provide both ¬-
nancing and maintenance. IBM was one of the pioneers of operating lease
contracts, and computers and of¬ce copying machines, together with auto-
mobiles, trucks, and medical diagnostic equipment, are the primary types of
equipment involved in operating leases. Operating leases typically require the
lessor to maintain and service the leased equipment, with the cost of mainte-
nance built into the lease payments.
Additionally, operating leases are not fully amortized, in that the pay-
ments required under the lease contract are not suf¬cient for the lessor to
recover the full cost of the equipment. However, the lease contract is written
for a period considerably less than the expected useful life of the leased asset,
and the lessor expects to recover all costs eventually either by lease renewal
payments or by sale of the equipment.
A ¬nal feature of operating leases is that they frequently contain a can-
cellation clause that gives the lessee the right to cancel the lease and return the
equipment to the lessor prior to lease expiration. This is an important consid-
eration to the lessee because it means that the equipment can be returned if it
is rendered obsolete by technological developments or it is no longer needed
because of a decline in the lessee™s business.

Financial Leases
Financial leases are differentiated from operating leases in that (1) they typi-
cally do not provide for maintenance; (2) they typically are not cancelable; (3)
they are generally for a period that approximates the useful life of the asset;
and hence (4) they are fully amortized.
In a typical ¬nancial lease, the lessee selects the speci¬c item it requires,
and then it negotiates the price and delivery terms with the manufacturer. The
lessee then arranges to have a leasing ¬rm (lessor) buy the equipment from
Chapter 18: Lease Financing and Business Valuation

the manufacturer, and the lessee simultaneously executes a lease agreement
with the lessor.
The terms of a ¬nancial lease call for full amortization of the lessor™s
investment, plus a rate of return on the lease that is close to the percentage
rate the lessee would have paid on a secured term loan. For example, if a
radiology group practice would have to pay 10 percent for a term loan to buy
an x-ray machine, then the lessor would build in a return on the lease of about
10 percent. The parallel to borrowing is obvious in a ¬nancial lease. Under a
secured loan arrangement, the lender would normally receive a series of equal
payments just suf¬cient to amortize the loan and to provide a speci¬ed rate
of return on the outstanding loan balance. Under a ¬nancial lease, the lease
payments are set up exactly the same way”the payments are just suf¬cient to
return the full purchase price to the lessor plus a stated return on the lessor™s
A sale and leaseback is a special type of ¬nancial lease, often used with
real estate, which can be arranged by a user that currently owns some asset.
Here, the user sells the asset to another party and simultaneously executes
an agreement to lease the property back for a stated period under speci¬c
terms. In a sale and leaseback, the lessee receives an immediate cash payment
in exchange for a future series of lease payments that must be made to rent
the use of the asset sold.
Although the distinction between operating and ¬nancial leases has
historical signi¬cance, today many lessors offer leases under a wide variety of
terms. Therefore, in practice, leases often do not ¬t exactly into the operating
lease or ¬nancial lease category but combine some features of each.

1. What is the difference between an operating lease and a ¬nancial lease?
2. What is a sale and leaseback?

Tax Effects
For both investor-owned and not-for-pro¬t businesses, tax effects can play an
important role in the lease-versus-buy decision.

Investor-Owned Businesses
For investor-owned businesses, the full amount of each lease payment is a
tax-deductible expense for the lessee provided that the IRS agrees that a
particular contract is a genuine lease. This makes it important that lease
contracts be written in a form acceptable to the IRS. A lease that complies
with all of the IRS requirements for taxable businesses is called a guideline, or
tax-oriented, lease. In a guideline lease, ownership (depreciation) tax bene¬ts
accrue to the lessor and the lessee™s lease payments are fully tax deductible. A
564 Healthcare Finance

lease that does not meet the tax guidelines is called a non-tax-oriented lease.
For this type of lease, the lessee can only deduct the implied interest portion of
each lease payment. However, the lessee is effectively the owner of the leased
equipment; thus, the lessee obtains the tax depreciation bene¬ts.
The reason for the IRS™s concern about lease terms is that, without
restrictions, a business could set up a “lease” transaction that calls for very
rapid lease payments, which would be deductible from taxable income. The
effect would be to depreciate the equipment over a much shorter period than
the IRS allows in its depreciation guidelines. Therefore, if just any type of
contract could be called a lease and given tax treatment as a lease, then the
timing of lease tax shelters could be speeded up as compared with depreciation
tax shelters. This speed up would bene¬t the business, but it would be costly
to the government and hence to individual taxpayers. For this reason, the IRS
has established speci¬c rules that de¬ne a lease for tax purposes.
The primary point here is that if businesses are to obtain tax bene¬ts
from leasing, the lease contract must be written in a manner that will qualify
it as a true lease under IRS guidelines. Any questions about the tax status of
a lease contract must be resolved by the potential lessee prior to signing the

Not-for-Pro¬t Businesses
Not-for-pro¬t lessees also bene¬t from tax laws, but in a different way. Because
not-for-pro¬t ¬rms do not obtain tax bene¬ts from depreciation, the owner-
ship of assets has no tax value. However, lessors, who are all taxable businesses,
do bene¬t from ownership. In effect, when assets are owned by not-for-pro¬t
¬rms the depreciation tax bene¬t is lost, while when assets are leased, the tax
bene¬t is realized by the lessor rather than the lessee. This realized bene¬t, in
turn, can be shared with the lessee in the form of lower rental payments. Note,
however, that the cost of tax-exempt debt to not-for-pro¬t ¬rms can be lower
than the after-tax cost of debt to taxable ¬rms, so leasing is not automatically
less costly to not-for-pro¬t ¬rms than borrowing in the tax-exempt markets
and buying.
A special type of ¬nancial transaction has been created for not-for-
pro¬t businesses called a tax-exempt lease. The major difference between a
tax-exempt lease and a conventional lease is that the implied interest portion
of the lease payment is not classi¬ed as taxable income to the lessor. Thus, the
return portion of the lessor™s payment is exempt from federal income taxes.
The rationale for this tax treatment is that the interest paid on most debt
¬nancing used by not-for-pro¬t organizations is tax-exempt to the lender, and
a lessor is, in actuality, a lender. Tax-exempt leases provide a greater after-tax
return to lessors than do conventional leases, so some of this “extra” return
could be passed back to the lessee in the form of lower lease payments. Thus,
the lessee™s payments on tax-exempt leases could be lower than when the asset
is acquired by a not-for-pro¬t business through a conventional lease.
Chapter 18: Lease Financing and Business Valuation

1. What is the difference between a tax-oriented (guideline) lease and a
non-tax-oriented lease?
2. Why should the IRS care about lease provisions?
3. What is a tax-exempt lease?

Balance Sheet Effects
Under certain conditions, neither the leased asset nor the contract liabilities
(present value of lease payments) appear on the lessee™s balance sheet. For
this reason, leasing is often called off-balance sheet ¬nancing. This point is
illustrated in Table 18.1 by the balance sheets of two hypothetical healthcare
providers: B and L. Initially, the balance sheets of both ¬rms are identical, and
they both have debt ratios of 50 percent. Next, each ¬rm decides to acquire
a ¬xed asset that costs $100. Firm B borrows $100 and buys the asset, so
both an asset and a liability are entered on its balance sheet, and its debt ratio
rises from 50 to 75 percent. Firm L leases the equipment. The lease may call
for ¬xed charges as high or even higher than the loan, and the obligations
assumed under the lease may have equal or even more potential to force the
business into bankruptcy, but the ¬rm™s debt ratio remains at only 50 percent.
To correct this accounting de¬ciency, accounting rules require ¬rms
that enter into certain leases to restate their balance sheets to report the leased
asset as a ¬xed asset and the present value of the future lease payments as a
liability. This process is called capitalizing the lease, and hence such a lease is
called a capital lease. The net effect of capitalizing the lease is to cause Firms B
and L to have similar balance sheets, both of which will, in essence, resemble
the one shown for Firm B.2

TABLE 18.1
Before Asset Increase:
Effects of
Firms B and L Leasing on
Current assets $ 50 Debt $ 50 Balance Sheets
Fixed assets 50 Equity 50
Total assets $100 $100

Debt/assets ratio 50%

After Asset Increase:
Firm B, which Borrows and Buys Firm L, which Leases
Current assets $ 50 Debt $150 Current assets $ 50 Debt $ 50
Fixed assets 150 Equity 50 Fixed assets 50 Equity 50
Total assets $200 $200 Total assets $100 $100

Debt/assets ratio 75% Debt/assets ratio 50%
566 Healthcare Finance

The logic here is as follows. If a ¬rm signs a capital lease contract, its
obligation to make lease payments is just as binding as if it had signed a loan
agreement; the failure to make lease payments has the potential to bankrupt a
¬rm just as the failure to make principal and interest payments on a loan can
result in bankruptcy. Therefore, under most circumstances, a capital lease has
the same impact on a business™s ¬nancial risk as does a loan. This being the
case, if a ¬rm signs a capital lease agreement, it has the effect of raising the
¬rm™s effective debt ratio. Therefore, to maintain the ¬rm™s established target
capital structure, the lease ¬nancing requires additional equity support exactly
like debt ¬nancing. Another way of saying the same thing is that leasing uses
up a business™s debt capacity.
Note, however, that there are some legal differences between loans and
leases, mostly involving the rights of lessors versus lenders when a business in
¬nancial distress reorganizes or liquidates under bankruptcy. In most ¬nancial
distress situations, lessors fare better than lenders, so lessors may be more
willing to deal with ¬rms in poor ¬nancial condition than are lenders. At a
minimum, lessors may be willing to accept lower rates of return than lenders
when dealing with ¬nancially distressed businesses because the risks are lower.
If disclosure of the lease in our Table 18.1 example were not made, then
Firm L™s investors might be deceived into thinking that its ¬nancial position is
stronger than it really is. Thus, even before businesses were required to place
some leases on the balance sheet, they were required to disclose the existence
of all leases longer than one year in the footnotes to their ¬nancial statements.
At that time, some people argued that investors fully recognized the impact of
leases and, in effect, would conclude that Firms B and L are essentially in the
same ¬nancial position. Conversely, other people argued that investors would
be better served if all leases were capitalized (shown directly on the balance
sheet). Current accounting requirements represent a compromise between
these two positions, although one that is tilted heavily toward those who favor
A lease is classi¬ed as a capital lease and thus is shown directly on the
balance sheet, if one or more of the following conditions exist:

• Under the terms of the lease, ownership of the property is effectively
transferred from the lessor to the lessee.
• The lessee can purchase the property at less than its true market value
when the lease expires.
• The lease runs for a period equal to or greater than 75 percent of the
asset™s life. Thus, if an asset has a ten-year life and the lease is written for
eight years, the lease must be capitalized.
• The present value of the lease payments, when discounted at the rate of
interest the lessee would have to pay if the asset were debt ¬nanced, is
equal to or greater than 90 percent of the initial value of the asset. Note
Chapter 18: Lease Financing and Business Valuation

that any maintenance payments embedded in the lease payment must be
stripped out prior to checking this condition.

These rules, together with strong footnote disclosure rules for noncap-
italized (operating) leases, are suf¬cient to ensure that no one will be fooled
by lease ¬nancing. In effect, a capital lease for a particular asset has the same
economic consequences for the business as does a loan in which the asset is
pledged as collateral. Thus, leases are regarded as debt for capital structure
purposes, and they have roughly the same effects as debt on the ¬nancial con-
dition of the ¬rm.
In closing, note that in most cases leases that meet IRS guidelines are
operating leases that will not be capitalized, while leases that do not meet IRS
guidelines are ¬nancial leases that will be capitalized. Remember, however,
that even operating (noncapitalized) leases must be disclosed in the footnotes
to the ¬rm™s ¬nancial statements.

1. Why is lease ¬nancing sometimes called off-balance sheet ¬nancing?
2. How are leases accounted for on a business™s balance sheet?

Lease Evaluation
Leases are evaluated by both the lessee and the lessor. The lessee must deter-
mine whether leasing an asset is less costly than obtaining equivalent alterna-
tive ¬nancing and buying the asset, and the lessor must decide what the lease
payments must be to produce a rate of return consistent with the riskiness of
the investment. Here, we will only cover the lessee™s analysis.3
To begin, note that a degree of uncertainty exists regarding the theoret-
ically correct way to evaluate lease-versus-purchase decisions, and some very
complex decision models have been developed to aid in the analysis. However,
the simple analysis given here, coupled with judgment, is suf¬cient to avoid
situations where a lessee enters into a lease agreement that is clearly not in
the business™s best interests. In the typical case, the events that lead to a lease
arrangement are as follows:

• The business decides to acquire a particular building or piece of
equipment; this decision is based on the capital budgeting procedures
discussed in Chapters 14 and 15. The decision to acquire the asset is not
at issue in a typical lease analysis; this decision was made previously as part
of the capital budgeting process. In lease analysis, we are concerned simply
with whether to obtain the use of the property by lease or by purchase.
• Once the business has decided to acquire the asset, the next question is
how to ¬nance its acquisition. A well-run business does not have excess
568 Healthcare Finance

cash lying around and, even if it does, there are opportunity costs
associated with its use.
• Funds to purchase the asset could be obtained from excess cash, by
borrowing or, if the business is investor-owned, by selling new equity.
Alternatively, the asset could be leased.

As indicated previously, a lease is comparable to a loan in the sense that
the business is required to make a speci¬ed series of payments and that failure
to meet these payments could result in bankruptcy. Thus, the most appropriate
comparison when making lease decisions is the cost of lease ¬nancing versus
the cost of debt ¬nancing, regardless of how the asset actually would be
¬nanced if it were not leased. The asset may be purchased with available
cash if not leased or ¬nanced by a new equity sale, but because leasing is
a substitute for debt ¬nancing the appropriate comparison would still be to
debt ¬nancing.
To illustrate the basic elements of lease analysis, consider this simpli¬ed
example. Nashville Radiology Group (the Group) requires the use of an x-ray
machine for two years that costs $100, and the Group must choose between
leasing and buying the equipment. (The actual cost is $100,000, but let™s keep
the numbers simple.) If the machine is purchased, the bank would lend the
Group the needed $100 at a rate of 10 percent on a two-year, simple interest
loan. Thus, the Group would have to pay the bank $10 in interest at the end of
each year, plus return the $100 in principal at the end of Year 2. For simplicity,
assume that the Group could depreciate the entire cost of the machine over
two years for tax purposes by the straight-line method if it were purchased,
resulting in tax depreciation of $50 in each year. Furthermore, the Group™s
tax rate is 40 percent. Thus, the depreciation expense produces a tax savings,
or tax shield, of $50 — 0.40 = $20 in each year. Also for simplicity, assume
the equipment™s value at the end of two years (its residual value) is estimated
to be $0.
Alternatively, the Group could lease the asset under a guideline lease
for two years for a payment of $55 at the end of each year. The analysis for the
lease-versus-buy decision consists of (1) estimating the cash ¬‚ows associated
with borrowing and buying the asset; (2) estimating the cash ¬‚ows associ-
ated with leasing the asset; and (3) comparing the two ¬nancing methods to
determine which has the lower cost. Here are the borrow and buy ¬‚ows:

Cash Flows if the Group Buys Year 0 Year 1 Year 2
Equipment cost ($100)
Loan amount 100
Interest expense ($10) ($ 10)
Tax savings from interest 4 4
Principal repayment (100)
Tax savings from depreciation 20 20
Net cash ¬‚ow $ 0 $14 ($ 86)
Chapter 18: Lease Financing and Business Valuation

The net cash ¬‚ow is zero in Year 0, positive in Year 1, and negative in Year 2.
Because the operating cash ¬‚ows (the revenues and operating costs) will be
the same regardless of whether the equipment is leased or purchased, they can
be ignored. Cash ¬‚ows that are not affected by the decision at hand are said
to be nonincremental to the decision.
Here are the cash ¬‚ows associated with the lease:
Cash Flows if the Group Leases Year 0 Year 1 Year 2
Lease payment ($55) ($55)
Tax savings from payments 22 22
Net cash ¬‚ow $0 ($33) ($33)

Note that the two sets of cash ¬‚ows re¬‚ect the tax savings associated with
interest expense, depreciation, and lease payments, as appropriate. If the lease
had not met IRS guidelines, then ownership would effectively reside with the
lessee, and the Group would depreciate the asset for tax purposes whether it
was “leased” or purchased. Furthermore, only the implied interest portion of
the lease payment would be tax deductible. Thus, the analysis for a nonguide-
line lease would consist of simply comparing the after-tax ¬nancing ¬‚ows on
the loan with the after-tax lease-payment stream.
To compare the cost streams of buying and leasing, we must put them
on a present value basis. As we explain later, the correct discount rate is the
after-tax cost of debt, which for the Group is 10% — (1 ’ T) = 10% — (1 ’
0.4) = 6.0%. Applying this rate, we ¬nd the present value cost of buying to
be $63.33 and the present value cost of leasing to be $60.50. Because leasing
has the lower present value of costs, it is the less-costly ¬nancing alternative,
so the Group should lease the asset.
This simpli¬ed example shows the general approach used in lease ana-
lysis, and it also illustrates a concept that can simplify the cash ¬‚ow estimation
process. Look back at the loan-related cash ¬‚ows if the Group buys the
machine. The after-tax loan-related ¬‚ows are ’$6 in Year 1 and ’$106 in
Year 2. When these ¬‚ows are discounted to Year 0 at the 6.0 percent after-tax
cost of debt, their present value is ’$100, which is the negative of the loan
amount shown in Year 0. This equality results because we ¬rst used the cost
of debt to estimate the future ¬nancing ¬‚ows, and we then used this same rate
to discount the ¬‚ows back to Year 0, all on an after-tax basis. In effect, the
loan amount positive cash ¬‚ow and the loan cost negative cash ¬‚ows cancel
one another out. Here is the cash ¬‚ow stream associated with buying the asset
after the Year 0 loan amount and the related Year 1 and Year 2 ¬nancing ¬‚ows
have been removed:
Cash Flows if the Group Buys Year 0 Year 1 Year 2
Cost of asset ($100)
Tax savings from depreciation $20 $20
Net cash ¬‚ow ($100) $20 $20
570 Healthcare Finance

The present value cost of buying here is, of course, $63.33, which is the same
amount we found earlier. The consistency between the two approaches will
always occur regardless of the speci¬c terms of the debt ¬nancing: As long as
the discount rate is the after-tax cost of debt, the cash ¬‚ows associated with
the loan can be ignored.
To examine a more realistic example of lease analysis, consider the
following lease-versus-buy decision that faces the Nashville Radiology Group:

• The Group plans to acquire a new computer system that will automate the
Group™s clinical records as well as its accounting, billing, and collection
process. The system has an economic life of eight years and costs
$200,000, delivered and installed. However, the Group plans to lease the
equipment for only four years because it believes that computer
technology is changing rapidly, and it wants the opportunity to reevaluate
the situation at that time.
• The Group can borrow the required $200,000 from its bank at a
before-tax cost of 10 percent.
• The system™s estimated scrap value is $5,000 after eight years of use, but
its estimated residual value, which is the value at the expiration of the
lease, is $20,000. Thus, if the Group buys the equipment, it would expect
to receive $20,000 before taxes when the equipment is sold in four years.
• The Group can lease the equipment for four years at a rental charge of
$57,000, payable at the beginning of each year. However, the lessor will
own the equipment upon the expiration of the lease. (The lease payment
schedule is established by the potential lessor and the Group can accept it,
reject it, or attempt to negotiate the terms.)
• The lease contract stipulates that the lessor will maintain the computer at
no additional charge to the Group. However, if the Group borrows and
buys the computer, it will have to bear the cost of maintenance, which
would be performed by the equipment manufacturer at a ¬xed contract
rate of $2,500 per year, payable at the beginning of each year.
• The computer falls into the MACRS ¬ve-year class life, the Group™s
marginal tax rate is 40 percent, and the lease quali¬es as a guideline lease
under a special IRS ruling.

Dollar Cost Analysis
Table 18.2 illustrates a complete dollar cost analysis. Again, our approach
here is to compare the dollar cost of owning (borrowing and buying) the
computer to the cost of leasing the computer. All else the same, the lower
cost alternative is preferable. Part I of the table is devoted to the costs of
borrowing and buying. Here, Line 1 gives the equipment™s cost, and Line 2
shows the maintenance expense, both of which are shown as out¬‚ows. Note
that whenever an analyst is setting up cash ¬‚ows on a time line, one of the
¬rst decisions to be made is what time interval will be used”that is, months,
Chapter 18: Lease Financing and Business Valuation

quarters, years, or some other period. As a starting point, we generally assume
that all cash ¬‚ows occur at the end of each year. If, at some point later in the
analysis, we conclude that another interval is better, we will change. Longer
intervals, such as years, simplify the analysis but introduce some inaccuracies
because all cash ¬‚ows do not actually occur at year end. For example, tax
bene¬ts occur quarterly because businesses pay taxes on a quarterly basis.
On the other hand, shorter intervals, such as months, often are used for
lease analyses because lease payments typically occur monthly. For ease of
illustration, we are using annual ¬‚ows in this example.
Line 3 gives the maintenance tax savings: because maintenance expense
is tax deductible, the Group saves 0.40 — $2,500 = $1,000 in taxes by virtue
of paying the maintenance fee. Line 4 contains the depreciation tax savings,
which equals the depreciation expense times the tax rate. For example, the
MACRS allowance for the ¬rst year is 20 percent, so the depreciation expense
is 0.20 — $200,000 = $40,000 and the depreciation tax savings is 0.40 —
$20,000 = $16,000.
Lines 5 and 6 contain the residual value cash ¬‚ows: the residual value
is estimated to be $20,000, but the tax book value after four years of depreci-
ation is $200,000 ’ $40,000 ’ $64,000 ’ $38,000 ’ $24,000 = $34,000.
(See Note a to Table 18.2.) Thus, the Group is losing $14,000 for tax pur-
poses, which results in the 0.4 — $14,000 = $5,600 tax savings shown as an
in¬‚ow on Line 6. Line 7, which sums the component cash ¬‚ows, contains the
net cash ¬‚ows associated with borrowing and buying.

TABLE 18.2
Year 0 Year 1 Year 2 Year 3 Year 4
I. Cost of Owning (Borrowing and Buying)
Group: Dollar
1. Net purchase price ($200,000)
Cost Analysis
2. Maintenance cost (2,500) ($ 2,500) ($ 2,500) ($ 2,500)
3. Maintenance tax savings 1,000 1,000 1,000 1,000
4. Depreciation tax savings 16,000 25,600 15,200 $ 9,600
5. Residual value 20,000
6. Residual value tax 5,600
7. Net cash ¬‚ow ($ 201,500) $ 14,500 $ 24,100 $ 13,700 $ 35,200
8. PV cost of owning ($ 126,987)

II. Cost of Leasing
9. Lease payment ($ 57,000) ($ 57,000) ($ 57,000) ($ 57,000)
10. Tax savings 22,800 22,800 22,800 22,800
11. Net cash ¬‚ow ($ 34,200) ($ 34,200) ($ 34,200) ($ 34,200) $ 0
12. PV cost of leasing ($ 125,617)

III. Cost Comparison
13. Net advantage to leasing (NAL) = PV cost of leasing ’ PV cost of owning
= ’$125,617 ’ (’$126,987) = $1,370.

Notes : a. The MACRS depreciation allowances are 0.20, 0.32, 0.19, and 0.12 in Years 1 through 4, respectively.
b. In practice, a lease analysis, such as this, would be done on a monthly basis using a spreadsheet program.
572 Healthcare Finance

Part II of Table 18.2 contains an analysis of the cost of leasing. The lease
payments, shown on Line 9, are $57,000 per year; this rate, which includes
maintenance, was established by the prospective lessor and offered to the
Group. If the Group accepts the lease, the full amount will be a deductible
expense, so the tax savings, shown on Line 10, is 0.40 — Lease payment =
0.40 — $57,000 = $22,800. The net cash ¬‚ows associated with leasing are
shown on Line 11.
The ¬nal step is to compare the net cost of owning with the net cost
of leasing, so we must put the annual cash ¬‚ows associated with owning and
leasing on a common basis. This requires converting them to present values,
which brings up the question of the proper rate at which to discount the net
cash ¬‚ows. We know that the riskier the cash ¬‚ows, the higher the discount
rate that should be applied to ¬nd the present value. This principle was applied
in both security valuation and capital budgeting analysis, and it also applies to
lease analysis. Just how risky are the cash ¬‚ows under consideration here? Most
of them are relatively certain, at least when compared with the types of cash
¬‚ows associated with stock investments or with the Group™s operations. For
example, the loan payment schedule is set by contract, as is the lease payment
schedule. Depreciation expenses are established by law and not subject to
change, and the annual maintenance fee is ¬xed by contract as well. The tax
savings are somewhat uncertain, because they depend on the Group™s future
marginal tax rates. The residual value is the riskiest of the cash ¬‚ows, but, even
here, the Group™s management believes that its risk is minimal.
Because the cash ¬‚ows under the lease and under the borrow and pur-
chase alternatives are both relatively certain, they should be discounted at a
relatively low rate. Most analysts recommend that the ¬rm™s cost of debt ¬-
nancing be used, and this rate seems reasonable in our example. However,
the Group™s cost of debt”10 percent”must be adjusted to re¬‚ect the tax de-
ductibility of interest payments because this bene¬t of borrowing and buying
is not accounted for in the cash ¬‚ows. Thus, the Group™s effective cost of debt
becomes Before-tax cost — (1 ’ Tax rate) = 10% — 0.6 = 6.0%. Accordingly,
the cash ¬‚ows in Lines 7 and 11 are discounted at a 6.0 percent rate. The
resulting present values are $126,987 for the cost of owning and $125,617
for the cost of leasing, as shown on Lines 8 and 12. Leasing is the lower-cost ¬-
nancing alternative, so the Group should lease, rather than buy, the computer.
The cost comparison can be formalized by de¬ning the net advantage
to leasing (NAL) as follows:

NAL = PV cost of leasing ’ PV cost of owning
= ’$125, 617 ’ (’$126, 987) = $1, 370.
The positive NAL shows that leasing creates more value than buying, so the
Group should lease the equipment. Indeed, the value of the Group is increased
by $1,370 if it leases, rather than buys, the computer system.
Chapter 18: Lease Financing and Business Valuation

TABLE 18.3
Year 0 Year 1 Year 2 Year 3 Year 4
1. Leasing cash ¬‚ow ($ 34,200) ($34,200) ($34,200) ($34,200) $ 0
2. Less: Owning cash ¬‚ow (201,500) 14,500 24,100 13,700 35,200
Percentage Cost
3. Leasing versus owning CF $167,300 ($48,700) ($58,300) ($47,900) ($35,200)
NAL = $1,370.
IRR = 5.6%.

Percentage Cost Analysis
The Group™s lease-versus-buy decision can also be analyzed by looking at the
effective cost rate on the lease and comparing it to the after-tax cost rate on the
loan. If the cost rate implied in the lease contract is less than the 6.0 percent
after-tax loan cost, then there is an advantage to leasing.
Table 18.3 sets forth the cash ¬‚ows needed to determine the percentage
cost of the lease. Here is an explanation of the table:

• The ¬rst step is to calculate the leasing-versus-owning cash ¬‚ows, which
are obtained by subtracting the owning cash ¬‚ows, Line 7 from Table
18.2, from the leasing cash ¬‚ows shown on Line 11. The differences,
shown on Line 3 of Table 18.3, are the incremental cash ¬‚ows to the
Group if it leases rather than buys the computer.
• Note that Table 18.3 consolidates the analysis shown in Table 18.2 into a
single set of cash ¬‚ows. At this point, we can discount the consolidated
cash ¬‚ows by 6.0 percent to obtain the NAL of $1,370. In Table 18.2, we
discounted the owning and leasing cash ¬‚ows separately and then
subtracted their present values to obtain the NAL. In Table 18.3, we
subtracted the cash ¬‚ows ¬rst to obtain a single set of incremental ¬‚ows
and then found their present value. The end result is the same.
• The consolidated cash ¬‚ows provide a good insight into the economics of
leasing. If the Group leases the computer, it avoids the Year 0 $167,300
net cash outlay required to buy the equipment, but it is then obligated to
a series of cash out¬‚ows for four years.
• By inputting the leasing-versus-owning cash ¬‚ows listed in Table 18.3 into
the cash ¬‚ow registers of a calculator and solving for IRR (or by using a
spreadsheet™s IRR function), we can ¬nd the cost rate inherent in the cash
¬‚ow stream”5.6 percent. This is the equivalent after-tax cost rate implied
in the lease contract. Because this cost rate is less than the 6.0 percent
after-tax cost of a loan, leasing is less expensive than borrowing and
buying. Thus, the percentage cost analysis con¬rms the dollar cost (NAL)

Some Additional Points
So far, we have discussed the main features of a lessee™s analysis. Here are some
additional points of relevance:
574 Healthcare Finance

• The dollar cost and percentage cost approaches will always lead to the
same decision. Thus, one method is as good as the other from a decision
• If the net residual value cash ¬‚ow (residual value and tax effect) is
considered to be much riskier than the other cash ¬‚ows in the analysis, it is
possible to account for this risk by applying a higher discount rate to this
¬‚ow, which results in a lower present value. Because the net residual value
¬‚ow is an in¬‚ow in the cost of owning analysis, a lower present value leads
to a higher present value cost of owning. Thus, increasing residual value
risk decreases the attractiveness of owning an asset. To illustrate the
concept, assume that the Group™s managers believe that the computer™s
residual value is much riskier than the other ¬‚ows in Table 18.2.
Furthermore, they believe that 10.0 percent, rather than 6.0 percent, is
the appropriate discount rate to apply to the residual value ¬‚ows. When
the Table 18.2 analysis is modi¬ed to re¬‚ect this risk, the present value
cost of owning increases to $129,780, while the NAL increases to $4,163.
The riskier the residual value, all else the same, the more favorable leasing
becomes because residual value risk is borne by the lessor.
• Remember that net present value (NPV) is the dollar present value of a
project, assuming that it is ¬nanced using debt and equity ¬nancing. In
lease analysis, the NAL is the additional dollar present value of a project
attributable to leasing, as opposed to conventional (debt) ¬nancing. Thus,
as an approximation of the value of a leased asset to the business, the
project™s NPV can be increased by the amount of NAL:

Adjusted NPV = NPV + NAL.
The value added through leasing, in some cases, can turn unpro¬table
(negative NPV) projects into pro¬table (positive adjusted NPV) projects.

Self-Test 1. Explain how the cash ¬‚ows are structured in conducting a dollar cost
Questions (NAL) analysis.
2. What discount rate should be used when lessees perform lease analyses?
3. What is the economic interpretation of the net advantage to leasing?
4. What is the economic interpretation of a lease™s IRR?

Motivations for Leasing
Although we do not prove it here, leasing is a zero-sum game; that is, when
both the lessor and the lessee have the same inputs (equal costs, tax rates, resid-
ual value estimates, and so on), a positive NAL for the lessee creates an equal,
but negative, return (NPV) for the lessor. Thus, under symmetric conditions,
it would be impossible to structure a lease that would be acceptable to both
Chapter 18: Lease Financing and Business Valuation

the lessee and lessor, and hence no leases would be written. The large amount
of leasing activity that actually takes place is driven by differentials between
the lessee and the lessor. In this section, we discuss some of the differentials
that motivate lease agreements.

Tax Differentials
Many leases are driven by tax differentials. Historically, the typical tax asym-
metry arose between highly taxed lessors and lessees with suf¬cient tax shields
(primarily depreciation) to drive their tax rates very low, even to zero. In these
situations, the asset™s depreciation tax bene¬ts could be taken by the lessor,
and then this value would be shared with the lessee. In addition, other pos-
sible tax motivations exist including tax differentials between not-for-pro¬t
providers and investor-owned lessors.

The Alternative Minimum Tax (AMT)
Taxable corporations are permitted to use accelerated depreciation and other
tax shelters to reduce taxable income but, at the same time, use straight-line
depreciation for stockholder reporting. Thus, under the normal procedure
for determining federal income taxes, many very pro¬table businesses report
large net incomes but pay little or no federal income taxes. The alternative
minimum tax (AMT), which roughly amounts to 20 percent of pro¬ts as
reported to shareholders, is designed to force pro¬table ¬rms to pay at
least some taxes. Those ¬rms that are exposed to heavy tax liabilities under
the AMT naturally seek ways to reduce reported income. One way is to
use high-payment short-term leases, which increase the business™s expenses
and consequently lowers reported pro¬ts and AMT liability. Note that the
lease payments do not have to qualify as a deductible expense for regular tax
purposes; all that is needed is that they reduce reported income shown on the
income statement.

Ability To Bear Obsolescence (Residual Value) Risk
Leasing is an attractive ¬nancing alternative for many high-tech items that are
subject to rapid and unpredictable technological obsolescence. For example,
assume that a small, rural hospital plans to acquire a magnetic resonance
imaging (MRI) device. If it buys the MRI equipment, it is exposed to the risk
of technological obsolescence. In a relatively short time, some new technology
might be developed that makes the current system nearly worthless, which
could create a ¬nancial burden on the hospital. Because it does not use much
equipment of this nature, the hospital would bear a great deal of risk if it buys
the MRI device.
Conversely, a lessor that specializes in state-of-the-art medical equip-
ment might be exposed to signi¬cantly less risk. By purchasing and then leas-
ing many different high-tech items, the lessor bene¬ts from portfolio diversi¬-
cation; over time, some items will lose more value than the lessor expected, but
576 Healthcare Finance

these losses will be offset by other items that retain more value than expected.
Also, because specialized lessors are familiar with the markets for used medical
equipment, they can both estimate residual values better and negotiate bet-
ter prices when the asset is resold (or leased to another business) than can a
hospital. Because the lessor is better able to bear residual value risk than the
hospital, the lessor could charge a premium for bearing this risk that is less
than the risk premium inherent in ownership.
Some lessors also offer programs that guarantee that the leased asset will
be modi¬ed as necessary to keep it abreast of technological advancements.
For an increased rental fee, lessors will provide upgrades to keep the leased
equipment current regardless of the cost. To the extent that lessors are better
able to forecast such upgrades; negotiate better terms from manufacturers;
and, by greater diversi¬cation, control the risks involved with such upgrades,
it may be cheaper for users to ensure state-of-the art equipment by leasing
than by buying.

Ability to Bear Utilization Risk
A type of lease that is gaining popularity among healthcare providers is the
per procedure lease. In this type of lease, instead of a ¬xed annual or monthly
payment, the lessor charges the lessee a ¬xed amount for each procedure
performed. For example, the lessor may charge the hospital $300 for every
scan performed using a leased MRI device, or it may charge $400 per scan for
the ¬rst 50 scans in each month and $200 for each scan above 100. Because
the hospital™s reimbursement for MRI scans depends primarily on the amount
of utilization, and because the per procedure lease changes the hospital™s costs
for the MRI from ¬xed to variable, the hospital™s risk is reduced.
However, the conversion of the payment to the lessor from a known
amount to an uncertain stream increases the lessor™s risk. Although the passing
of risk often produces no net bene¬t, a per procedure lease can be bene¬cial
to both parties if the lessor is better able to bear the utilization risk than is the
lessee. As before, if the lessor has written a large number of per procedure
leases, then some of the leases will be more pro¬table than expected and
some will be less pro¬table than expected; but if the lessor™s expectations are
unbiased, the aggregate return on all leases will be quite close to that expected.

Ability to Bear Project Life Risk
Leasing can also be attractive when a business is uncertain about how long
an asset will be needed. To illustrate the concept, consider the following
example. Hospitals sometimes offer services that are dependent on a single
staff member”for example, a physician who performs liver transplants. To
support the physician™s practice, the hospital might have to invest millions of
dollars in equipment that can be used only for this particular procedure. The
hospital will charge for the use of the equipment, and if things go as expected,
the investment will be pro¬table. However, if the physician dies or leaves the
Chapter 18: Lease Financing and Business Valuation

hospital staff, and if no other quali¬ed physician can be recruited to ¬ll the
void, then the project must be abandoned and the equipment becomes useless
to the hospital. In this situation, the annual usage may be quite predictable,
but the need for the asset could suddenly cease.
A lease with a cancellation clause would permit the hospital to simply
return the equipment to the lessor. The lessor would charge something for the
cancellation clause because such clauses increase the riskiness of the lease to
the lessor. The increased lease cost would lower the expected pro¬tability of
the project, but it would provide the hospital with an option to abandon the
equipment, and such an option could have a value that exceeds the incremental
cost of the cancellation clause. The leasing company would be willing to write
this option because it is in a better position to remarket the equipment, either
by writing another lease or by selling it outright.

Maintenance Services
Some businesses ¬nd leasing attractive because the lessor is able to provide
maintenance services on favorable terms. For example, MEDTRANS, Inc.,
a for-pro¬t ambulance and medical transfer service that operates in Pennsyl-
vania, recently leased 25 ambulances and transfer vans. The lease agreement,
with a lessor that specializes in purchasing, maintaining, and then reselling
automobiles and trucks, permitted the replacement of an aging ¬‚eet that
MEDTRANS had built up over seven years. “We are pretty good at providing
emergency services and moving sick people from one facility to another, but
we aren™t very good at maintaining an automotive ¬‚eet,” said MEDTRANS™s

Lower Information Costs
Leasing may be ¬nancially attractive for smaller businesses that have limited
access to debt markets. For example, a small, recently formed physician group
practice may need to ¬nance one or more diagnostic devices such as an EKG
machine. The group has no credit history, so it would be relatively dif¬cult,
and hence costly, for a bank to assess the group™s credit risk. Some banks might
think the loan is not even worth the effort. Others might be willing to make
the loan but only after building the high cost of credit assessment into the cost
of the loan. On the other hand, some lessors specialize in leasing to medical
practices, so their analysts have assessed the ¬nancial worthiness of hundreds,
or even thousands, of such businesses. Thus, it would be relatively easy for
them to make the credit judgment, and hence they might be more willing to
provide the ¬nancing, and charge lower rates, than conventional lenders.

Lower Risk in Bankruptcy
Finally, leasing may be less expensive than buying to ¬rms that are poor
credit risks. As discussed earlier, in the event of ¬nancial distress leading to
reorganization or liquidation, lessors generally have more secure claims than
578 Healthcare Finance

do lenders. Thus, lessors may be willing to write leases to ¬rms with poor
¬nancial characteristics that are less costly than loans offered by lenders, if
such loans are even available.

There are other reasons that might motivate businesses to lease an asset
rather than buy it. Often, these reasons are dif¬cult to quantify, so they cannot
be easily incorporated into a numerical analysis. Nevertheless, a sound lease
analysis must begin with a quantitative analysis, and then qualitative factors
can be considered before making the ¬nal lease-or-buy decision.

Self-Test 1. What are some economic factors that motivate leasing”that is, what
Questions asymmetries might exist that make leasing bene¬cial to both lessors and
2. Would it ever make sense to lease an asset that has a negative NAL when
evaluated by a conventional lease analysis? Explain your answer.

Business Valuation
Entire businesses, as opposed to individual projects, are valued for many rea-
sons including for acquisitions, buyouts, and the assessment of taxes. Al-
though many different approaches can be used to value businesses, we will
focus on the two most commonly used in the health services industry: the
discounted cash ¬‚ow and market multiple approaches.
Regardless of the valuation approach, it is crucial to understand three
concepts that affect valuations. First, if the valuation is for acquisition pur-
poses, the business being valued typically will not continue to operate as a
separate entity but will become part of the acquiring business™s portfolio of
assets. Thus, any changes in ownership form or operations that occur as a result
of the proposed merger that would affect the value of the business must be
considered in the analysis. Second, the goal of most valuations is to estimate
the value of the business™s equity because most valuations are to assess the
value of an ownership, as opposed to creditor, position. Thus, although we
use the phrase “business valuation,” the ultimate goal is to value the ownership
stake in the business rather than its total value. Finally, business valuation is
a very imprecise process. The best that can be done, even by professional
appraisers who conduct these valuations on a regular basis, is to attain a rea-
sonable valuation rather than a precise one.

Discounted Cash Flow Approach
The discounted cash ¬‚ow (DCF) approach to valuing a business involves the
application of classical capital budgeting procedures to an entire business. To
apply this approach, two key items are needed: (1) a set of statements that
Chapter 18: Lease Financing and Business Valuation

estimate the cash ¬‚ows expected from the business; and (2) a discount rate to
apply to these cash ¬‚ows.
The development of accurate cash ¬‚ow forecasts is, by far, the most
important step in the DCF approach. Table 18.4 contains projected pro¬t
and loss statements for Doctors™ Hospital, an investor-owned hospital that is
being valued by its owners for possible future sale. Doctors™ currently uses 50
percent debt (at book values), and it has a 40 percent marginal federal-plus-
state tax rate.
Line 1 of Table 18.4 contains the forecast for Doctors™ net revenues,
including both patient services revenue and other revenue. Note that all
contractual allowances and other adjustments to charges, including collection
delays, have been considered, so Line 1 represents actual cash revenues. Lines
2 and 3 contain the cash expense forecasts, while Line 4 lists depreciation”
a noncash expense. Line 5, which is merely Line 1 minus Lines 2, 3, and
4, contains the earnings before interest and taxes (EBIT) projection for each
year. Note that if the valuation were being conducted by another business that
was considering making an acquisition bid for Doctors™ Hospital, the revenue
and expense amounts would re¬‚ect any utilization, reimbursement, and cost
ef¬ciencies that would occur as a result of the acquisition.
Note that the interest expense values shown on Line 6 include interest
on current debt as well as interest on debt issued to fund growth. In addition
to interest expense, any debt principal repayments that will not be funded by
new debt must be re¬‚ected in Table 18.4. Because such payments are made
from after-tax income, they would be placed on a line below net pro¬t”
say, on a new Line 9a. Line 7 contains the earnings before taxes (EBT),
and Line 8 lists the taxes based on Doctor™s 40 percent marginal rate. Note
here that any tax rate changes that would result from an acquisition must
be incorporated into the pro¬t and loss statement forecasts. Line 9 lists each
year™s net pro¬t.

TABLE 18.4
2005 2006 2007 2008 2009
1. Net revenues $ 105.0 $ 126.0 $ 151.0 $ 174.0 $ 191.0 Hospital:
2. Patient services expenses 80.0 94.0 111.0 127.0 137.0 Projected Pro¬t
3. Other expenses 9.0 12.0 13.0 16.0 16.0
and Loss
4. Depreciation 8.0 8.0 9.0 9.0 10.0
Statements and
5. Earnings before interest
and taxes (EBIT) $ 8.0 $ 12.0 $ 18.0 $ 22.0 $ 28.0
6. Interest 4.0 4.0 5.0 5.0 6.0
7. Earnings before taxes (EBT) $ 4.0 $ 8.0 $ 13.0 $ 17.0 $ 22.0 (in millions)
8. Taxes (40 percent) 1.6 3.2 5.2 6.8 8.8
9. Net pro¬t $ 2.4 $ 4.8 $ 7.8 $ 10.2 $ 13.2

10. Estimated retentions $ 4.0 $ 4.0 $ 7.0 $ 9.0 $ 12.0
580 Healthcare Finance

Finally, because some of Doctors™ assets are expected to wear out or
become obsolete, and because the hospital must grow its assets to support
projected revenue growth, some equity funds (shown on Line 10) must be
retained and reinvested in the subsidiary to pay for asset replacement and
growth. These retentions, which would be matched by equal amounts of
new debt, are not available for distribution to shareholders.
Table 18.5 provides relevant cost of capital data for Doctors™ Hospital.
These data will be used to set the discount rate used in the DCF valuation. As
with many healthcare valuations, there is no market beta available to help
establish the cost of equity. Doctor™s Hospital is investor owned but not
publicly traded, while in other situations the business could be not-for-pro¬t.
However, we can obtain market betas of the stocks of the major investor-
owned hospital chains, and this value could be used to help estimate the cost
of equity given in Table 18.5. It is important to realize that the discount rate
used in the DCF valuation must re¬‚ect the riskiness of the cash ¬‚ows being
discounted. If the valuation is for acquisition purposes, and if the riskiness
of the cash ¬‚ows will be affected by the acquisition, then the cost of capital
calculated for the business must be adjusted to re¬‚ect any expected changes
in risk.
The cost of equity estimate in Table 18.5 merits additional discussion.
The cost of equity estimate based on market data, which is what we have
focused on in the text thus far, is applicable to large publicly-traded compa-
nies whose stock is owned by well-diversi¬ed investors. For example, in the
Doctors™ Hospital illustration, the cost of equity of large hospital manage-
ment companies was estimated to be 14 percent. However, such companies
are highly diversi¬ed both geographically and in the types of services provided.
In addition, equity (stock) ownership in such companies is very liquid”if a
stockholder wants out, he or she simply calls a broker and sells the shares.
Thus, a “traditional” large company cost of equity estimate does not re¬‚ect
the added risks inherent in an equity position in a small, undiversi¬ed business
whose stock is illiquid. Thus, it is necessary to add an additional premium to
account for the added risks associated with ownership of a small company.
This premium, called the size premium, is thought to be about four percent-

TABLE 18.5
Cost of equity 18.0%
Cost of debt 10.0%
Hospital: Proportion of debt ¬nancing 0.50
Proportion of equity ¬nancing 0.50
Selected Cost
Tax rate 40.0%
of Capital Data
CCC = [wd — R (Rd ) — (1 ’ T)] + [we — R (Re )]
= [0.50 — 10.0% — (1 ’ 0.40)] + [0.50 — 18.0%]
= 3.0% + 9.0% = 12.0%.

Note: If necessary, see Chapter 13 for a discussion of the corporate cost of capital (CCC).
Chapter 18: Lease Financing and Business Valuation

age points. Thus, Doctors™ cost of equity estimate is actually based on a 14
percent estimate for similar large companies plus a four percentage point size
premium: 14% + 4% = 18%. If there were other factors in addition to size,
such as heavy use of new, unproven technology or extreme illiquidity or lack of
portfolio diversi¬cation, that would increase the risk of ownership even more,
an additional risk premium would be added to compensate for the unique
riskiness inherent in that particular small company. We will use 18 percent
as our estimate for Doctors™ cost of equity, but an even higher rate probably
could be justi¬ed.
At this point, there are several alternative cash ¬‚ow/discount rate com-
binations that could be used to complete the DCF valuation. The most widely
used DCF method for business valuation, the free equity cash ¬‚ow method, fo-
cuses on cash ¬‚ows that accrue solely to equityholders (owners). Free equity
cash ¬‚ow is de¬ned as net pro¬t plus noncash expenses (depreciation), less
equity cash ¬‚ow needed for reinvestment in the business. Table 18.6 uses the
data contained in Table 18.4 to forecast the free equity cash ¬‚ows for Doctors™.
In valuation analyses, the term “free” means cash ¬‚ows that are available to
the owners after all other expenses, including asset replacement to support
growth, have been taken into account.
The next step in the DCF valuation process is to choose the appropriate
discount rate (cost of capital). Unlike a typical capital budgeting analysis that
focuses on operating cash ¬‚ows, our DCF business valuation focuses on equity
¬‚ows. Thus, the discount rate applied must re¬‚ect the riskiness of cash ¬‚ows
after interest expense is deducted, which have greater risk than do operating
¬‚ows. What capital cost re¬‚ects the riskiness of these higher-risk equity ¬‚ows?
The answer is, the cost of equity. This means that the appropriate discount
rate to apply to the Table 18.6 cash ¬‚ows is the 18 percent cost of equity
shown in Table 18.5, not the 12 percent corporate cost of capital.
Because we have projected only ¬ve years of cash ¬‚ows, and because
Doctors™ Hospital will generate cash ¬‚ows for many years (perhaps 20 or 30
years or more), it is necessary to estimate a terminal value. If the free equity
cash ¬‚ows given in Table 18.6 are assumed to grow at a constant rate after
2009, the constant growth model can be used to estimate the value of all free
equity cash ¬‚ows that would occur in 2010 and beyond. Assuming a constant
3 percent growth rate in free equity cash ¬‚ow forever, the terminal value at
the end of 2009 is estimated to be $76.9 million:4

TABLE 18.6
2005 2006 2007 2008 2009
1. Net pro¬t $ 2.4 $ 4.8 $ 7.8 $ 10.2 $ 13.2 Hospital:
2. Plus depreciation 8.0 8.0 9.0 9.0 10.0 Projected Free
3. Less retentions 4.0 4.0 7.0 9.0 12.0
Equity Cash
4. Free equity cash ¬‚ow $ 6.4 $ 8.8 $ 9.8 $ 10.2 $ 11.2
(in millions)
582 Healthcare Finance

2009 Free equity cash ¬‚ow — (1 + Growth rate)
Terminal value =
Required rate of return ’ Growth rate
$11.2 — 1.03 $11.54
= =
0.18 ’ 0.03 0.15
= $76.9 million.
Combining the free equity cash ¬‚ows from Table 18.6 with the terminal
value calculated above produces the following set of ¬‚ows (in millions):

2004 2005 2006 2007 2008 2009

$6.4 $8.8 $9.8 $10.2 $11.2

The ¬nal step in the DCF valuation process is to discount the time line cash
¬‚ows at the cost of equity”18.0 percent. The resulting present (2004) value is
$61.5 million. Thus, the DCF method estimates a value for Doctors™ Hospital
of about $60 million.
Although we will not illustrate it here, the valuation would include
a risk analysis of the cash ¬‚ows that is similar to that performed on capital
budgeting ¬‚ows. Generally, scenario analysis (and perhaps Monte Carlo sim-
ulation) would be used to obtain some feel for the degree of uncertainty in
the ¬nal estimate, which might further be used to set a valuation range rather
focus on a single estimate.

Market Multiple Approach
A second method for valuing entire businesses is market multiple analy-
sis, which applies a market-determined multiple to some proxy for value”
typically some measure of revenues or earnings. Like the DCF valuation ap-
proach, the basic premise here is that the value of any business depends on the
cash ¬‚ows that the business produces. The DCF approach applies this premise
in a precise manner, while market multiple analysis is more ad hoc.
To illustrate the concept, suppose that recent data of for-pro¬t hospi-
tals indicate that equity values average about four to ¬ve times the business™s
EBITDA, which means earnings before interest, taxes, depreciation, and amor-
tization. Thus, we would say that the EBITDA market multiple is 4“5. To
estimate the value of Doctors™ equity using this method, note that Doctors™
2005 EBITDA estimate is $8 million in EBIT plus $8 million in deprecation,
or $16 million. Multiplying EBITDA by the 4.5 average market multiple gives
an equity value of $72.0 million. Because of the uncertainties involved in the
market multiple process, we will use $70 million as our estimate.
Chapter 18: Lease Financing and Business Valuation

Comparison of the Valuation Methods
Clearly, the valuation of a business can only be considered a rough estimate.
In the Doctors™ Hospital illustration, we obtained values for the business of
$60 and $70 million. Thus, we might conclude that the value of Doctors™
Hospital falls somewhere in the range of $60 to $70 million. In many “real-
world” valuations, the range is even larger than in our example. Because the
estimates of the two methods can differ by large amounts, it is important to
understand the advantages and disadvantages of each method.
Although the DCF approach has strong theoretical support, one has
to be very concerned over the validity of the estimated cash ¬‚ows and the
discount rate applied to those ¬‚ows. Sensitivity analyses demonstrate that it
doesn™t take much change in the terminal value growth rate or discount rate
estimates to create large differences in estimated value. Thus, the theoretical
superiority of the DCF approach is offset to some degree by the dif¬culties
inherent in estimating the model™s input values.
The market multiple method is more ad hoc, but its proponents argue
that a proxy estimate for a single year, such as measured by EBITDA, is more
likely to be accurate than a multiple-year cash ¬‚ow forecast. Furthermore, the
market multiple approach avoids the problem of having to estimate a terminal
value. Of course, the market multiple approach has problems of its own. One
concern is the comparability between the business being valued and the ¬rm
(or ¬rms) that set the market multiple. Another concern is how well one year,
or even an average of several years, of EBITDA captures the value of a business
that will be operated for many years into the future.

1. Brie¬‚y describe two approaches commonly used to value businesses.
2. What are some problems that occur in the valuation process?
3. Which approach do you believe to be best? Explain your answer.

Key Concepts
In this chapter, we discussed both leasing decisions and business valuation.
The key concepts of this chapter are:
• Lease agreements are informally categorized as either operating leases or
¬nancial (capital ) leases.
• The IRS has speci¬c guidelines that apply to lease arrangements. A lease
that meets these guidelines is called a guideline, or tax-oriented, lease
because the IRS permits the lessee to deduct the lease payments. A lease
that does not meet IRS guidelines is called a non-tax-oriented lease. In such
leases, ownership effectively resides with the lessee rather than the lessor.
• Accounting rules spell out the conditions under which a lease must be
capitalized (shown directly on the balance sheet), as opposed to being
shown only in the notes to the ¬nancial statements. Generally, leases that
584 Healthcare Finance

run for a period equal to or greater than 75 percent of the asset™s life must
be capitalized.
• The lessee™s analysis consists of a comparison of the costs and bene¬ts
associated with leasing the asset and the costs and bene¬ts associated with
owning (borrowing and buying) the asset. There are two analytical
techniques that can be used: the dollar-cost (NAL) method and the
percentage-cost (IRR) method.
• One of the key issues in the lessee™s analysis is the appropriate discount
rate. Because the cash ¬‚ows in a lease analysis are known with relative
certainty, the appropriate discount rate is the lessee™s after-tax cost of debt. A
higher discount rate may be used on the residual value if it is substantially
riskier than the other ¬‚ows.
• Leasing is motivated by differentials between lessees and lessors. Some of
the more common reasons for leasing are (1) tax rate differentials,
(2) alternative minimum taxes, (3) residual risk bearing, and (4) lack of
access to conventional debt markets.
• Two approaches are most commonly used to value businesses: the
discounted cash ¬‚ow approach and the market multiple approach.
• The free equity cash ¬‚ow approach, which is a commonly used DCF
method, focuses on the cash ¬‚ows that are available to equity investors.


. 20
( 21)