MHC6305 WEEK 4 LECTURE
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Long-Term Debt Financing
When you buy a house, you examine financing plans offered by banks and loan companies. The terms include options such as repayment over fifteen to thirty years and adjustable or fixed interest rates and may include points for origination or to buy down the rate. There are a lot of categories of closing costs. There was probably a review of your credit worthiness to determine if you could reasonably be expected to make the repayments. This area was overlooked in the housing crisis that occurred in 2008. If you build a house, there are construction terms and inspections to release funds for the builder and materials, followed by a conversion to conventional finance. There is a requirement for a loan to value down payment so that you have significant “skin in the game” or commitment to the project. All of this is true when a business finances the purchase of major equipment or construction of new facilities. However, there is another step that shows that the expense is the best one that can be made among the available alternatives, that is, the projected return is the best and the risk is the lowest. A hospital may have to decide whether to buy a new Magnetic Resonance Imaging (MRI) machine or build a new emergency room (ER) wing. It must decide which alternative will offer the most bang for the buck—the highest return—and, if it fails, not cause great harm to the financial health of the organization. While this may seem fairly straightforward from a financial perspective, realize that other executives will also want to explore the competition and the projected future of the community in terms of health and growth. The community likely has an economic development agency that has much of the information needed such as projections of businesses or colleges coming to town.
Long-term financing is one way of raising capital. A second way is through equity financing. Equity refers to ownership, which is raised by selling stock in your organization. In case of a nonprofit organization, donations from the community are similar to equity.
Long-term financing is one way of raising capital. A second way is through equity financing. Equity refers to ownership, which is raised by selling stock in your organization. In case of a nonprofit organization, donations from the community are similar to equity. Equity financing has strings attached, but these are different from those of long-term debt financing. In debt financing, you must return the money over time; in equity financing, you must give up a portion of the ownership of the organization, maybe even a major part. This means that you have given up some of the say in the management of the organization. Instead of making interest payments, you will be expected to make dividend payments. That is, the new owner or the partial owner shares the profits of the organization. An important concept involved in equity financing is constant growth. The goal of the organization is to have dividends rise every quarter and the stock of the organization price rise in lockstep with the dividends. When this happens, the growth in dividends as a percentage of stock price is zero. If the dividends rose but the stock price fell, the dividends as a percentage of the stock price would rise a great deal. As long as the financials show that the organization is sound, people would see that it is paying high dividends and would be attracted to the stock, which would cause it to rise again. A look at the Standard & Poor’s 500 or other market shows that the average dividend is 2%–3%. When a stock has a dividend of 15%, it indicates a very risky organization that may be on the verge of ruin.
An important concept involved in equity financing is constant growth. The goal of the organization is to have dividends rise every quarter and the stock of the organization price rise in lockstep with the dividends. When this happens, the growth in dividends as a percentage of stock price is zero. If the dividends rose but the stock price fell, the dividends as a percentage of the stock price would rise a great deal. As long as the financials show that the organization is sound, people would see that it is paying high dividends and would be attracted to the stock, which would cause it to rise again. A look at the Standard & Poor’s 500 or other market shows that the average dividend is 2%–3%. When a stock has a dividend of 15%, it indicates a very risky organization that may be on the verge of ruin.
Capital structure refers to the proportions of debt and equity carried by an organization. This is an important consideration. For example, when an economy is going into recession, there is risk in carrying a lot of debt on the balance sheet. If income goes down as a result of the economic downturn, the organization may not be able to make interest payments and risks a default. In the same circumstance, in case of equity, dividends may be reduced without incurring default risk. Most businesses, whether for profit or nonprofit, have both types of financing on the books. It is the balance between them that is an important choice managers make. Each organization must consider both the risk situation and the cost of capital and decide on the balance at any particular time. The balance may change many times as conditions change. So what is the cost of capital? That is much of the topic of study in this unit and involves the interest rate that must be paid to the lender in the case of long-term debt or the dividend in the case of equity financing. In either case, the risk premium must be added, and this is usually around 6% for a large business that is stable. Adding the interest rate to 6% gives a rough estimate of the cost of capital. For a small organization, that would be about 15%. This means that any investment has a simple hurdle rate of about 15%, that is, the net income target for the investment to break even is 15%.
The choice between debt and equity financing is one type of risk–return trade-off. The use of debt financing can leverage the return to owners or, in not-for-profit firms, the return on fund capital, but it also increases the riskiness of the business.
Long-term investment method and equity investment are both used extensively in healthcare, and it would be wise for you to begin to understand these methods.
Investopedia. (2016). Capital asset pricing model – CAPM [Video]. Available from http://www.investopedia.com/video/play/capm/
Some useful concepts
A Compilation of Concepts in Finance
The following is a collection of important concepts in healthcare finance taken from different sources. It is important to your understanding of many of the processes found in healthcare finance. This list is not all-inclusive, so, add to this list as you progress in your studies. In many cases the original article has much more information, so the sources are included.
Individual choice over health insurance policies may result in risk-based sorting across plans. Such adverse selection induces three types of losses: efficiency losses from individuals being allocated to the wrong plans; risk sharing losses since premium variability is increased; and losses from insurers distorting their policies to improve their mix of insureds (Cutler &Zeckhauser, 1998).
Someone out there knows more than you about whatever you are looking into investing in. This is the basic theory of asymmetric information. There is a difference in knowledge for every security out there (Reeves, 2013).
Capitation is a payment method for health care services. The physician, hospital, or other health care provider is paid a contracted rate for each member assigned, referred to as “per-member-per-month” rate, regardless of the number or nature of services provided. The contractual rates are usually adjusted for age, gender, illness, and regional differences (Mosby, 2009).
Cash is King
Cash is the king in finance. Net income, revenue, and other forms of measurement for businesses are not nearly as important as the operating cash flows of a firm. Cash cannot be manipulated by accounting procedures and represents an unbiased benchmark for where the firm stands. Cash is also the most liquid form of payment and represents only inflation and depreciation risk. Other forms of payment can possess delinquency risks among other things. When dealing with schedules, remember that cash is the best option for your firm when accepting payment (Reeves, 2013).
If you’ve ever wondered why financial experts are always telling people to take advantage of tax-deferred 401(k) and IRA accounts, the mystery is solved. Compound interest is the reason. If you put $10,000 into an index fund earning 6% interest and do nothing, it will be worth $57,434.91 in thirty years. That’s because the interest on your original $10,000 is itself earning interest with each passing year. Of course, the returns are even sweeter if you continue putting money in, but the power of compound interest should now be clear. Furthermore, with a Roth IRA, all of this accumulated growth is untouched by income taxes.
This is also known as the “good deals disappear fast” phenomenon. Chances are that if you think you see a good deal because of a news release, it has already been bid up to reflect the news. Other items include arbitrage opportunities. Arbitrage is when an investor can perform a series of transactions and receive a profit without any risk. Risk free arbitrage sometimes happens because of market inefficiencies. However, once these opportunities are identified by analysts, they are quickly taken advantage of until they disappear (Reeves, 2013).
Expected Value is a specific and immensely useful application of probability. In simplest terms, it is an expression of the long-term average odds that something will happen. You get it by taking an outcome and multiplying it by the probability that it will happen. The number you wind up with is the Expected Value of that action. While this might sound like abstruse financial jargon, it is anything but. Everyone who buys lottery tickets, for instance, is either unaware of or ignoring the concept of Expected Value. Based on the calculations just described, forking over $10 for buys you a piece of paper with an Expected Value of $5. Seen from this perspective, buying lottery tickets actually reduces your net worth. An index fund, on the other hand, is an example of something with a positive Expected Value that could rationally be expected to grow your net worth (Reybern, 2013).
Fee-for-service (FFS) is a payment model where services are unbundled and paid for separately. In health care, it gives an incentive for physicians to provide more treatments because payment is dependent on the quantity of care, rather than quality of care. Similarly, when patients are shielded from paying (cost-sharing) by health insurance coverage, they are incentivized to welcome any medical service that might do some good. FFS is the dominant physician payment method in the United States (Berenson & Rich, 2010).
Greater Return Requires Greater Risk
This is one of the oldest financial concepts in the books. It is a simple relation between risk and return. Risk and return is one of the most correlated relationships in finance. For return to increase, you absolutely must take on more risk. If there are securities where this isn’t true, then the one with the better risk-return relationship will be bought, and the other will not (Reeves, 2013).
You might have heard various analysts and experts claim that some low rate of return (say, 1% or 2%) “doesn’t even beat inflation.” Inflation refers to a gradual, yearly rise in the prices of everything in the economy. Because the government prints more money each year, it loses its buying power at a rate of between 2%-4% annually. In other words, $500 today can buy more goods and services than it will buy a year or two from now. According to the Heritage Foundation, Social Security provides low or even negative returns to various segments of society because of inflation. When making financial decisions (such as evaluating investment performance or yearly income) you must always determine the inflation-adjusted, or “real” rate of return. Neglecting inflation creates a rosier picture, but is nothing more than an exercise in self-delusion.
Borrowing money (also known as leverage) is another common source of confusion among the public. Besides attributing high or low interest rates to greed and favoritism, many people fail to comprehend the basic, underlying mechanics of borrowing. The idea of interest can prove especially confusing. Yet, it is crucial to understand what is actually happening when you borrow money. Take the easy example of a car loan. While your new car might cost, say, $28,000, borrowing the full purchase price costs far more than that. Using a cost of loan calculator, we find that borrowing $28,000 at 6% interest and repaying it over 5 years costs $32,479 when all is said and done.
Moral hazard is the term used to describe the fact that insurance can change the behavior of the person being insured. If you have a no-deductible fire-insurance policy, you may be a little less diligent in clearing the brush away from your house. Insurance can have the paradoxical effect of producing risky and wasteful behavior. Insurance is an attempt to make human life safer and more secure. The fear of moral hazard lies behind the thicket of co-payments , deductibles, and utilization reviews which characterizes the American healthcare system (Gadwell, 2005).
Opportunity cost refers to the value of your foregone options. The opportunity cost of attending college, for instance, might be the income you could earn at a job if you weren’t in school. The opportunity cost of going to a party might be a lower grade on the test because you didn’t study. Every choice in life, big and small, entails opportunity costs. Nor are they always this obvious. Many “do it yourself” projects are actually a waste of time and/or money when opportunity cost is considered. Let’s say it takes you six hours to do your own taxes, during which you cannot work on your business. If six hours working on the business would have produced more than the cost of an accountant, doing it yourself was a waste. To view it any other way is sheer mental accounting. While you did not physically hand money over, the greater sum of business income you sacrificed means you should have.
Probability seeks to measure how likely it is that various things will happen and express those odds as a percentage. A coin toss, for instance, has a probability of 50% because it is equally likely that it will flip heads or tails. Banks use probability (albeit in more complicated ways) to determine the odds that borrowers of various creditworthiness will repay their loans and, thus, what interest rate to charge. While many believe that banks charge high or low interest out of “greed” or “favoritism”, it is ultimately a total numbers game. If probability shows that borrowers with your characteristics pay on time, you pay less. If it shows the opposite, you pay more. Understanding probability can put such decisions into perspective and empower you to make better ones yourself (Reybern, 2013).
Within a hospital, the traditional revenue cycle begins with contracting. A medical center’s payer-relations team negotiates reimbursement levels for patients with different health plans. These patients are then scheduled for various inpatient and outpatient services. They are registered — providing significant personal data including financial information — and as they receive care, case managers work with insurance companies to ensure that the care is appropriate and will be paid based upon the contract and on industry-standard practice guidelines. When the patient is discharged, the medical record is coded and the insurance company is billed. The patient may or may not have personal liability for some of the final bill. When the entire account is paid, the balance settles at $0, unless the insurance company or a government auditor determines that there was some error, creating a “post-payment denial.”( Gillikin, 2013)
Time Value of Money
Money is more valuable the earlier in time you receive the payment. Every moment you wait to receive payment could have been spent investing that money into the market and earning a return. This applies to small businesses negotiating payment schedules and other cash flow arrangements. Getting the money sooner is always a better option than receiving it later. Receiving the money also alleviates the risk that the paying party will not come through on their side of the contract. Delinquency of accounts can really add some costs to a small business, so make sure you receive your payments as soon as possible (Reeves, 2013).
While probability is about predictions, statistics is about measurement. Generally speaking, there are two kinds of statistics: descriptive and inferential. Descriptive statistics simply reflect the inarguable facts of the data. The heights, weights, genders and eye color of a thousand randomly assembled people would be examples of descriptive statistics. Inferential statistics go a step further by attempting to draw conclusions from the descriptive ones. An example of an inferential statistic might be a theory about how “80% of all people living in this area have brown eyes.” Statistics, like probability, is used across the economy and shapes billions of financial decisions large and small every single day (Reybern, 2013).
A sunk cost is an amount of money that has already been spent and cannot be recovered. Cars purchased, years spent in careers and portions of meals already consumed are all sunk costs. Unfortunately, because human beings are naturally risk-averse, we are often slow to acknowledge sunk costs and change course. We frequently hear friends or relatives justify staying at jobs they despise because of all the time they’ve worked there. Others will actually force themselves to choke down disgusting restaurant food to “get their money’s worth.” But all they are doing is throwing good money after bad by prolonging the original mistake. Instead, true financial rationality demands that you emotionlessly cut your losses as soon as a sunk cost is recognized. Time and money already spent (and which you cannot get back) should not affect what you decide to do next (Reybern, 2013).
Berenson, R. & Rich, E. (June 2010). US approaches to physician payment: The deconstruction of primary care. Journal of General Internal Medicine 25 (6), 613–618.
Cutler, David M. and Richard J. Zeckhauser. (1998). Adverse selection in health insurance. Forum for
Health Economics and Policy, v1, Article 2.
Gillikin, J. (2013). Definition of revenue cycle management. Retreived August 20, 2013 from
Gladwell, M. (2005, August). The moral hazard myth. New Yorker.
Mosby’s Medical Dictionary, 8th edition. 2009, Elsevier.
Reeves, C. (2013). Five concepts of finance. Retreived August 20, 2013 from
Reybern, S. (2013). 12 Important financial concepts. . Retreived August 20, 2013 from