chapter 8: capital financing for health care providers

Capital Financing for Health Care Providers

Chapter 8

Learning Objectives

• Describe the types of equity and debt financing

• Define various bond terminology

• Compare tax exempt with taxable financing

• Explain lease financing

Assets=Debt +Equity

• Any increase in assets must be balanced by a similar increase indebt or equity or both

• The structuring of debt relative to equity is called capitalstructure decision

• Important for both for profit and not for profit

• Industry changes can limit the access to debt and equityfinancing

• Strong cash flow and dominant market share position improvethe credit rating of a health care system

Equity Financing

Primary sources for not-for- profits

Internally generated funds

Philanthropy

Governmental grants

Sale of real estate including medical office buildings

Primary source for profits

Issuing stock

Retained earnings

Comparison of Stock and Debt Financing

Debt Financing

Alternative to equity financing

• Borrowing money from others at a cost

Several types

• Long Term Loans

• Bonds may be issued

Types of Debt Financing

• Maturity

• Term Loans- paid off within 10 years

• Bonds- maturity in 20-35 years

• Type of Interest Loan

• Fixed Interest rate debt

• Variable rate demand bonds

• Auction rate securities

• Interest rate swap

Selected Types of Health Care Debt Financing

• Bank Term Loans

• Conventional Mortgages

• Pooled Equipment Financing

• FHA Program Loans

• Bonds

• Tax Exempt Bonds

• Taxable Bonds

Bond Issuance Process

Bonds can be sold by either public or private placement

• In a public offering a bond is sold to the investing publicthrough an underwriter

• Private placements are sold to a particular institution orgroup of institutions

Bond Issuance Process• Can take 12-18 months before cash received

• Health care borrower updates its capital plan, measures its debtcapacity

• Borrower identifies and selects the key parties involved in thebond issuance process

• Borrower is evaluated by a credit rating agency

• Bond is rated by a credit rating agency

• Borrower enters into a loan agreement with a governmentalauthority, the issuer of bonds

• Underwriter sell bonds to bond holders at the public offeringand the trustee provides health care provider with the netproceed from the bond issuance

Financial Evaluation

Evaluation of a health care provider’s ability to pay

• Debt Service Coverage- one of the primary financial ratios used toevaluate a health care provider’s ability to meet debt servicepayments

𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 =𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 + 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 + 𝑨𝒎𝒐𝒓𝒕𝒊𝒛𝒂𝒕𝒊𝒐𝒏

𝑴𝒂𝒙𝒊𝒎𝒖𝒎 𝑨𝒏𝒏𝒖𝒂𝒍 𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆 𝑷𝑨𝒚𝒎𝒆𝒏𝒕𝒔

• Market evaluation: including local demographics (populationgrowth, income levels, unemployment rate in the market area);competition from other health care providers, penetration ofmanaged care etc.

• Physician and Management Evaluation

Bank Qualified or Direct Private Placement Loans

• Direct tax exempt loan bond purchase by a bank

Advantages

• Direct debt purchase is less time consuming and cheaper toissue

• Loan does not require a credit rating by a rating agency

• Loan avoids remarketing

• If a loan qualifies as bank qualified, the bank can deduct 80%of its interest costs which results in lower interest

Bond valuation

• Bond valuation (annual coupon payments):

• 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 = 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑋 𝑃𝑉𝐹𝐴 𝑘, 𝑛 +𝑃𝑎𝑟 𝑣𝑎𝑙𝑢𝑒 𝑋 𝑃𝑉𝐹 𝑘, 𝑛

• Bond valuation (semiannual periods for coupon payments):

• 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 = 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡/2 𝑋 𝑃𝑉𝐹𝐴 𝑘/

Bond valuation: Example 1

• If a $1000 zero coupon bond with a 30-year maturity has amarket price of $412, what is its rate of return?

Givens:

Par Value (FV) $1,000

Years to Maturity (nper) 30

Market Value (PV) $412.00

Solution:

Market Coupon Par

Value = Payment x PVFA(k,n) + Value x PVF(k,n)

$412.00 = $0.00 x PVFA(k,n) + $1,000.00 x PVF(k,n)

$412.00 = $0.00 x PVFA(k,30) + $1,000.00 x PVF(k,30)

$412.00 = $1,000.00 x PVF(k,30)

$412.00 / $1,000.00 = PVF(k,30)

0.412 = PVF(k,30)

k = 3% = 0.03 (from Table B-3 )

Example 2:

• If a $1000 zero coupon bond with a 10-year maturity has amarket price of $508.30, what is its rate of return?

Givens:

Par Value (FV) $1,000

Years to Maturity (nper) 10

Market Value (PV) $508.30

Solution:

Market Coupon Par

Value = Payment x PVFA(k,n) + Value x PVF(k,n)

$508.30 = $0.00 x PVFA(k,n) + $1,000.00 x PVF(k,n)

$508.30 = $0.00 x PVFA(k,10) + $1,000.00 x PVF(k,10)

$508.30 = $1,000.00 x PVF(k,10)

$508.30 / $1,000.00 = PVF(k,10)

0.5083 = PVF(k,10)

k = 7% = 0.07 (from Table B-3)

Example 3:

A tax exempt bond was recently issued at an annual 10 percentcoupon rate of return and matures 15 years from today. Thepar value of the bond is $1000.

d. At what required market rate (10%, 5%, or 14%) does theabove bond sell at a discount? At a premium.?

Givens:

Par Value $1,000

Years to Maturity 15

Coupon Rate 10%

a. Hypothetical Market Rate 10%

b. Hypothetical Market Rate 5%

c. Hypothetical Market Rate 14%

Solution: Market Coupon Par

Value = Payment x PVFA(k,n) + Value x PVF(k,n)

MV = $100.00 x PVFA(0.1,15) + $1,000.00 x PVF(0.1,15)

MV = $100.00 x 7.6061 + $1,000.00 x 0.2394

MV = $760.61 + $239.39

MV = $1000.00

Market Coupon Par

Value = Payment x PVFA(k,n) + Value x PVF(k,n)

MV = $100.00 x PVFA(0.05,15) + $1,000.00 x PVF(0.05,15)

MV = $100.00 x 10.3797 + $1,000.00 x 0.4810

MV = $1,037.97 + $481.02

MV = $ 1,518.98

Solution:

Market Coupon Par

Value = Payment x PVFA(k,n) + Value x PVF(k,n)

MV = $100.00 x PVFA(0.14,15) + $1,000.00 x PVF(0.14,15)

MV = $100.00 x 6.1422 + $1,000.00 x 0.1401

MV = $614.22 + $140.10

MV = $ 754.31

d.

When the market rate equals the coupon rate (part a), market value equals

par value.

When the market rate is below the coupon rate (part b), the bond sells at a

premium.

When the market rate is above the coupon rate (part c), the bond sells at a

discount.

Loan Amortization: Example 4

• The Johns Hopkington hospital needs to borrow $3million topurchase an MRI. The interest rate for the loan is 6%.Principal and interest payments are equal debt servicepayments, made on an annual basis. The length of the loan is5 years. The CFO of Johns Hopkington wants to develop aloan amortization schedule for this debt borrowing fortomorrow morning’s meeting. Prepare such a schedule?

Solution: Givens: (PV) $3,000,000

Interest rate (rate) 6%

Length of Loan (nper) 5

Present Annuity

Value = Amount x PVFA(0.06,5)

$3,000,000 = Annuity x 4.2124 (Table B-4)

Annuity = $3,000,000 / 4.2124

Annuity = $712,189

Solution:

Example 5:

• Laurel Regional hospital needs to borrow $80 million to finance its new facility. The interest rate for the loan is 8%. Principal and interest payments are equal debt service payments, made on an annual basis. The length of the loan is 10 years. The CEO would like to develop a loan amortization schedule for this debt borrowing for tomorrow morning’s meeting. Prepare such a schedule?

Givens: (PV) $80,000,000

Interest rate (rate) 8%

Length of Loan (nper) 10

Solution:

Present Annuity

Value = Amount x PVFA(0.06,5)

$80,000,000 = Annuity x 6.7101 (Table B-4)

Annuity = $80,000,000 / 6.7101

Annuity = $11,922,359

Solution:

Lease Financing

• Lessor: an entity that owns an asset that is then leased out.

• Lessee: An entity that negotiates the use of another’s assetvia a lease.

The lessor owns the asset, and the lessee makes lease paymentsto the lessor for the use of the asset.

Reasons for lease:

• Avoid the bureaucratic delays of capital budget requests

• Avoid technological obsolescence

• Receive better maintenance services

• Allow for convenience

Types of Lease• Operating lease- service equipment leased for periods shorter than

the equipment’s economic life (one year or less).

• This type of leasing arrangement can be canceled at any timewithout penalty, but there is no option to purchase the asset oncethe lease has expired.

• Capital Lease- lease the asset for all of its economic life possibleoption to buy.

• This type of lease cannot be cancelled without penalty, and at theend of the lease period, the lessee may have the option topurchase the asset.

Lease versus Purchase Decision

• Compare present value cost of a buy decision with the presentvalue cost of a lease over a specified time

• The option with the lower present value cost is preferable

• Many factors to consider

Purchase vs. Lease: Example Givens: (in thousands)

1. Before tax lease payments $15,000

2. Loan amount (PV) $55,000

3. Length of loan/lease (nper) 5

4. Interest rate (rate) 8%

5. After tax cost of debt 5%

6. Tax rate 40%

7. Annual depreciation expense [a] $11,000

8. Annual depreciation tax shield [b] $4,400

9. Annual loan payment [c] $13,775

10. Present value of lease @ interest rate [d] $59,891

Solution: Purchasing arrangement

Year [A]Loan payment

(given 9)

[B]Interest expense

[D]X[given 4]

[C]Principal payment

[A]-[B]

[D]Remaining balance

[D]-[C]

0 $55,000

1 $13,775 $4400 $9,375 45,625

Year [A]Loan payment

(given 9)

[B]Interest expense

[D]X[given 4]

[C]Principal payment

[A]-[B]

[D]Remaining balance

[D]-[C]

0 $55,000

1 $13,775 $4400 $9,375 45,625

2 $13,775 3,650 10,125 35,500

Solution: Purchasing arrangement

Year [A]Loan payment

(given 9)

[B]Interest expense

[D]X[given 4]

[C]Principal payment

[A]-[B]

[D]Remaining balance

[D]-[C]

0 $55,000

1 $13,775 $4400 $9,375 45,625

2 $13,775 3,650 10,125 35,500

3 $13,775 2840 10935 24,565

Solution: Purchasing arrangement

Year [A]Loan payment

(given 9)

[B]Interest expense

[D]X[given 4]

[C]Principal payment

[A]-[B]

[D]Remaining balance

[D]-[C]

0 $55,000

1 $13,775 $4400 $9,375 45,625

2 $13,775 3,650 10,125 35,500

3 $13,775 2840 10935 24,565

4 $13,775 1965 11810 12755

Solution: Purchasing arrangement

Year [A]Loan payment

(given 9)

[B]Interest expense

[D]X[given 4]

[C]Principal payment

[A]-[B]

[D]Remaining balance

[D]-[C]

0 $55,000

1 $13,775 $4400 $9,375 45,625

2 $13,775 3,650 10,125 35,500

3 $13,775 2840 10935 24,565

4 $13,775 1965 11810 12755

5 $13,775 1020 12755 0

Solution: Purchasing arrangement

Solution:Year [E]

Depreciation expense shield

[given 7]X[given 6]

[F]Interest expense

Tax shield[B]X[given 6]

[G]Net cash outflow (if

owned)[A]-[E]-[F]

[H]PVF (from table B-

3)After tax

Cost of debt[given 5]

[I]PV of net cash outflows

(if owned)[G]X[H]

0 $55,000

1 $4400 $1760 7615 0.9542 $7,266

2 $4400 1460 7915 0.9105 7,207

3 $4400 1136 8239 0.8688 7,158

4 $4400 786 8589 0.8290 7,120

5 $4400 408 8967 0.7910 7,093

$35,845

Leasing arrangementYear [A]

Before Tax Lease Payments

[Given 1]

[B]Lease tax

shield [A]X[given 6]

[C]After tax

Net lease payments[A]-[B]

[D]PVF

After taxCost of debt

[given 5]

[E]Cash outflows

(if leased)[C]X[D]

0

1 $15,000 $6,000 $9,000 0.9542 $8,588

2 $15,000 $6,000 $9,000 0.9105 8,194

3 $15,000 $6,000 $9,000 0.8688 7,819

4 $15,000 $6,000 $9,000 0.8290 7,461

5 $15,000 $6,000 $9,000 0.7910 7,119

$39,182

It is more expensive to lease the asset since the present valueof the lease payments ($39,182)is greater than that forborrowing ($35,845).

Summary

Three ways to finance debt

• Using debt (liabilities)

• Using equity

• Combination of debt and equity