HEALTH TRACKING: MARKETWATCH The Economics of for-Profit And Not-For-Profit Hospitals Nonprofit hospitals owe society community benefits in exchange for their tax exemption, but what is a fair amount? BY UWE E. REINHARDT ABSTRACT: This paper examines the economics capital acquisitions. The reasons for this diver of for-profit and not- for-profit hospitals through gence are(1)the typically higher cost of equity he prism of capital acquisitions the exercise capital that for-profit hospitals face; and (2)the suggests that of two hospitals that are equally income taxes they must pay. The paper recom- efficient in producing health care, the for-profit mends holding tax-exempt hospitals more for. hospital would have to charge higher prices than mally accountable for the social obligation they the not- for-profit hospital would to break even on shoulder, in return for their tax preference. UCH HAS BEEN SAID about the Finally, the analysis assumes that in each hos- level of the "playing field"on which pital, the machine would produce annually 178 M for-profit and not-for-profit hospi- 3, 100 units of service, for each of which $700 is tals compete for patients, revenues, and profit received in cash. Total annual cash operating margins. Leaders of the nonprofit sector argue expenses to produce these services are as- that for- profit hospitals enjoy the advantage sumed to be $1.2 million of easy access to"cheap"equity capital and, One hospital, which we shall call Health moreover, are not burdened with the pre- care Inc(hereafter HCI), is investor-owned. sumption that they owe society uncompen- It pays a tax of 35 percent on taxable profits sated community benefits. Leaders of the for- The other hospital, which we shall call Com profit sector counter that nonprofit hospitals munity Medical Center(hereafter CMC), is benefit from a variety of tax preferences and, nonprofit. It does not pay any income taxes moreover, need not pay any monetary returns and can borrow in the tax-exempt bond mar to anyone for the equity capital made avail- ket, a tax preference not available to the for- able to them. Each side regularly commissions profit hospital. For the sake of simplicity we research to bolster its case ignore property taxes, although they can con- aims into sharp focus by examining them posed mainly on the for-profit secto. ense im One can put these claims and counter- stitute a significant additional exp hrough the lens of capital acquisitions. To Because we intend to assess arguments is paper considers two hospitals that center strictly on the eco onomic advan serving the same market area, each contem- tages or disadvantages imputed to the two lating the acquisition of an identical piece of types of hospitals, we shall develop for each medical equipment that can be purchased for hospital a standard capital-budgeting exer $4 million in cash. It assumes that the equip- cise that would be used by a business firm ment in question has an estimated use life of That approach is realistic, because the mar six years and a zero salvage value after that. kets for hospital services tend to be marked Uwe Reinhardt is the James Madison Professor of Political Economy at Princeton university H D 2000 Project HOPE-The People-to. People Health Foundation, Inc. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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EALTH TRACKIN K ETWAT by high excess capacity, which forces even eventually collapse. Some observers may see nonprofits to focus heavily on profit margins. an economic advantage in the ability of for The exercise reveals that from a strictly profit entities to play this funny-money economic perspective, and other things being game-a game not available to the nonprofit equal, nonprofit hospitals do enjoy a decided sector. This is not the sort of economic advan advantage over for-profit hospitals. Although tage explored here for illustrative purposes that conclusion is de rived here from a specific numerical example, Evaluating Capital Acquisitions it is in fact quite general and would emerge Incremental operating cash income. from any other project evaluation. The tax The first step in evaluating the purely eco- preference enjoyed by the nonprofit sector is the main source of that advantage. In addi- nomic merits of acquiring capital equipment tion,however, nonprofit hospitals arguably Is to estimate what increment that acquisition may have a lower cost of financing as well. will add to the hospital's net cash operating Income each yea the equipment s use vantage does not stem from the nonprofit hos. life, other things being equal. The term net cash pital's ability to borrow in the tax-exempt matter in this evaluation and that net cash bond market. If the nonprofit does enjoy a lower cost of financing, that advantage would income is to be calculated after all cash oper ting expenses(such as labor and supplies) have to reside in a lower cost of equity capital. but prior to the deduction of interest expense Before proceeding with the formal analysis on debt(which I consider separately below) proposed here, it is worth noting that some For the tax paying HCI, this incremental net commentators on the for profit/nonprofit cash operating income would be calculated on controversy assume that the equity capital 179 ole to for- profit hospitals is particularly an after-tax basis. which means that it would cheaper even than debt include the tax savings HCI would achieve by example, Gary Claxton and colleagues have laiming tax-deductible depreciation expense remarked that on the machine . Exhibit l presents the incremental net o equity can be a cheaper method of raising capi erating cash flows attributable to the pro tal than debt, particularly for firms with good posed capital acquisition for each of the two growth potential whose stock may be valued at hospitals (after taxes for HCI. The differ high multiple of its current earnings in these cash flows is driven strictly by the tax Bradford Gray echoed that proposition status of the two hospitals. The cash flow Year 0 represents the initial outlay on the The higher the stock price in relationship to quipment. In its bottom two rows the ex- to equity capital?per the organizations access hibit also shows the so-called net present val ues and internal rates of return inherent in These authors have in mind here not the these cash flows, evaluation criteria that I ex cost of equity financing as it is defined in the plain further on theory of corporate finance and used in thi The second step in this capital-budgeting paper. Rather, they allude to the fact that exercise is to explore whether the projected through a cleverly staged program of acquir- stream of incremental net after-tax cash oper ing other firms in stock-for-stock mergers, an ating income expected from the proposed ac investor-owned firm can seduce Wall Street quisitic ficient to cover fully the after- into vastly(but temporarily) overvaluing the tax cost of financing that acquisition. As firm's common stock. That strategy effec- shown below, the cost of financing is calcu tively allows the firm to acquire real assets"on lated as a weighted average of the cost of debt the cheap, so to speak, with funny money and equity financing, where the weights re that it can print at will but whose value will flect the mix of debt and equity that the firm HEALTH AFFAIRS Noye nmber/dec r 2000 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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H EA LTH TRACKING: MARKETWATC H EXHIBIT 1 Net Cash Operating Income Flows For Two Hospitals, Hcl And CMc For-profit HcI's perspective Nonprofit CMCs perspective $4,O00.000 0123-456 9700 791500 970.o00 711,700 970,000 Net present value(PV $495097 Internal rate of return(IRR) 8.44 11.90% SOURCE: Authors analysis. seeks to maintain in its long-term financing chasers of the firms bonds seek to earn or strategy. This weighted average cost of finan- investments in bonds of this risk class, plus an cial capital (generally referred to as the allowance for the cost of issuing and selling WACC)takes the form of an interest rate. It new bonds through an investment banker is used to convert each future year's incre- Under our tax code, interest on its debt is a mental net cash operating income attribut- tax-deductible expense for a tax-pa 1B0 present-value equivalent. If one sums these therefore would be only 5.85 percent, that:g able to the proposed acquisition into its tity. HCl's after-tax cost of debt present-value equivalents over the use life of 9%x(1-0.35) the equipment and deducts from that sum the HCI can obtain equity capital either by initial cost of the acquisition, one obtains the selling new stock certificates in the open mar so-called net present value (NPV) of the ket or by retaining and reinvesting part of the decision to make the acquisition earnings that in principle belong to the cur ily be shown that if the estimated rent shareholders. In this exercise we assume NPV of a proposed acquisition is positive, that HCI's cost of equity financing is 15 per then the incremental net cash operating in- cent. This return can be bestowed on the come yielded by that acquisition is more than shareholders either in the form of annual cash dequate to cover the total cost of acquiring dividends or as capital gains-that is, through and financing it. The acquisition would be increases in the future market price of the made, because it is projected to enhance the firms stock. Should HCI fail to provide its firms economic value. On the other hand, if shareholders that expected rate of return, the estimated NPV were negative, then the then the market price of its common stock acquisition would not cover its cost of financ- would decline. Thus, one can view a firms ng. From a purely economic perspective, the cost of equity capital as the rate of return that cquisition should not be made, because it the firm must provide its shareholders on would detract from the firm's economic value. their investment in the firm's common stock The firm simply breaks even on the acquisi- merely to maintain the current market price tion if the Npv is projected to be zero of that stock. The imperative to maintain and Calculating HCI's cost of financing ideally, to enhance the market price of a for (WACC). We assume that HCI can sell newly profit hospital's common stock is a stringent issued bonds at a market price that implies an managerial constraint not faced by the man interest cost to HCI of 9 percent. This is the agers of ofit he annual rate of return that prospective pur- longer-term strategies without constant HEALTH AFFAIRS V oIume 19, N Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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HEALTH TRACKING: MARKETWAT Monday- morning quarterbacking by Wall the firms WACC is also commonly referred Street analyst to as its"hurdle rate"for capital acquisitions To appreciate why an investor-owned Calculating CMC's cost of financing firms cost of equity capital is so high, one (WACC). We assume that the nonprofit CMC According to modern finance theory, the rate bond market at an interest rate of 6. 3 percent, of return that the suppliers of equity capital to which includes, once again, the cost of selling a business firm expect from such investments new bonds through investment bankers. That has two distinct components. The first is the rate would be equivalent to a rate of 9 percent rate of return that these investors could have on a comparable taxable bond if the typical earned by investing their funds in a risk-free purchaser of such bonds faced a marginal tax asset, such as a long-term U.S. Treasury bond, rate of 30 percent. It is worth noting that rather than in the firms common stock. The based on our assumptions, HCIs after-tax second component is a premium for the risk cost of debt(calculated above as 5.85 percent hat the suppliers of equity capital assume by would actually be lower than CMC's cost of investing their funds in the common stock of borrowing via tax-exempt bonds, although this particular firm, rather than in the risk- that differential could go either way, depend free asset. Broadly speaking, risk in this con- ing on the marginal income tax rates that text means the considerable uncertainty drive tax-exempt bond yields in the market rounding the magnitude of the returns to In any event, contrary to conventional wi shareholders that are promised by the firm. dom, the ability of not- for-profit hospitals to That uncertainty depends on the firms par- borrow in the tax-exempt bond market actu ticular set of revenue- producing product lines ally does not bestow on them a significant and how strongly these revenue flows are in- economic advantage vis-a-vis the for-profit 181 fluenced by general economic conditions sector Under current tax laws, the returns that an As a nonprofit entity, CMC cannot pro investor-owned firm bestows on its share cure equity capital by selling ownership cer holders are not considered part of the firms tificates(common stock) in the open market tax-deductible business expenses. Therefore, Its equity capital comes from four othe HCI's cost of equity capital(assumed to be 15 sources. First, it may be supplied voluntarily percent) must be earned by the proposed by philanthropists. Second, it may be sup capital acquisition on an after-tax basis. If we plied involuntarily by members of the com- assume that over the longer term HCI seeks to munity who, as patients, have directly or indi finance its capital acquisitions with a mixture rectly (through their insurance premiums) of 40 percent debt and 60 percent equity, and paid the hospital higher than break-even that its pretax cost of debt is 9 percent, then prices for services rendered. Although osten the firms overall, weighted-average annual sibly nonprofit in orientation, many such in- after-tax cost of financing(its WACC) can be stitutions price their services to achieve an calculated as k =9%(1-0.35)(40%)+ excess of revenues over expenses, "the non- 15%(60%), which comes to 11.34 percent. This profit nomenclature for "profits "By law, is the interest rate at which HCI would con- however, the institutions may not distribute he ncre ental annual cash operating in- such profits to outsiders. Instead, they retain come it expects from the equipment into their them as equity capital to finance either asset present-value equivalent, to calculate the acquisitions or unrequited future community NPV of the proposed acquisition. That is, the services. Third, a nonprofit's equity capital is rate implies that for HCI to break even on the indirectly supplied by general taxpayers who proposed acquisition, the annual net after-tax must pay higher property and income taxes ash operating income per $100 sunk into that than they would have to pay if nonprofits equipment must be at least $11.34. This is why were taxed on their property and profits just HEALTH AFFAIRS noye m her m bcr2000 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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H EA LTH TRACKING M ARKETWATCH as for-profit entities are. Finally, in some in- cisely the kind of mutual funds in which the stances equity capital comes to the nonprofit nonprofit CMC might have parked its liquid through grants from governments or private equity funds That may be so Here we assume The question then arises, What annual cost of equity funds is a lower and safer p foundations initially, however, that CMC's opportunit cost should be assigned to the use of their percent, although subsequently we repeat the noted,unlike the shareholders of for- profit tals have the identical cost of financing. p/ equity capital by nonprofit institutions? As analysis on th e assump ption that both ho entities, those who supply equity capital to To keep the illustration simple, we assume the nonprofit sector do not expect a monetary that in its financing CMC, too, seeks to main return for their voluntary or involuntary "in- tain a debt-to-asset ratio of 40 percent over vestments"in that sector N he long run. With an assumed ther do they lie awake at night 'Higher prices cost of debt financing of 6.3 worrying rcent and a cost of equit risk(to them) from those"in could be capital of 9 percent, we can vestments. "Instead, society attempt by the for. then calculate CMC's WACC expects the nonprofit sector to ask=6.3%(40%)+9%(60%) reward its suppliers of equity profit hospital to which comes to 7.92 percent apital with purely psychic re compensate for its The rate implies that to break turns--with the knowledge even on the proposed acquisi that the nonprofits will pro- relative economic tion of the machine, CMC vide to society certain valuable disadvantage.” ould have to earn an benefits for which they are not net cash operating income of 182 directly compensated with at least $7.92 per $100 of fi cash revenue. A core issue in the for- nancing devoted to the acquisition profit/nonprofit debate always has been how large these psychic benefits have to be and Relative Profitability Of The how their magnitude should be measured Acquisition For the moment, we sidestep that difficult question by assuming that the equipment in At a WACC of 11. 34 percent, the NPV of the question would be purchased by either hospi would be a negative $309 463, which means hen seem logical to require that the proposed that HCI would not find the acquisition in its acquisition yield a sufficiently high stream of conomic interest. Only at a WACC as low as net cash operating income to cover the hospi percent would HCI break even on this acquisition. That break-even hurdle rate(see tal's cost of debt financing as well its opportu the bottom row of Exhibit 1) is commonly nity cost of drawing down the hospital's pool known as the internal rate of return(IRR)of the of liquid equity funds to finance this acquisI, acquisition tion. That opportunity cost can be me by the rate of return that CMC could have of 7.92 percent, the proposed acquisitA y contrast, at CMC's much lower WA earned on these funds had they been invested some broad common-stock portfolio- would have a positive NPVof $495,097, which such as a mutual fund-rather than in this implies that the acquisition would b articular piece of equipment. nomically advantageous to CMC. CMC would lose economic value with this acquisi It might be argued that the relevanxocely percent, the internal rate of return of the proj tunity cost of funds would be approxima tion only if its WACC were to exceed 11.90 equal to the for-profit HCI's cost of equity capital(here 15 percent). because the share ect from CMC's perspective This difference in profitability is, of ce holders of for-profit hospitals would be pre driven by both the tax preference enjoyed by HEALTH AFFAIRS Volumc 19, Nu m b 6 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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