By Calvin Weise CPA and Dr. David E. Marcinko MBA
The Weighted Average Cost of Capital
It is critical to understand and to measure the total cost of capital. Lack of understanding and appreciation of the total cost of capital is widespread, particularly among not-for-profit hospital executives. The capital structure includes long-term debt and equity; total capital is the sum of these two. Each of these components has cost associated with it. For the long-term debt portion, this cost is explicit: it is the interest rate plus associated costs of placement and servicing.
For the equity portion, the cost is not explicit and is widely misunderstood. In many cases, hospital capital structures include significant amounts of equity that has accumulated over many years of favorable operations. Too many executives wrongly attribute zero cost to the equity portion of their capital structure. Although it is correct that generally accepted accounting principles continue to assign a zero cost to equity, there is opportunity cost associated with equity that needs to be considered. This cost is the opportunity available to utilize that capital in alternative ways.
In general, the cost attributed to equity is the return expected by the equity markets on hospital equity. This can be observed by evaluating the equity prices of hospital companies whose equity is traded on public stock exchanges. Usually the equity prices will imply cost of equity in the range of 10% to 14%.
Almost always, the cost of equity implied by hospital equity prices traded on public stock exchanges will substantially exceed the cost of long-term debt. Thus, while many hospital executives will view the cost of equity to be substantially less than the cost of debt (i.e., to be zero), in nearly all cases, the appropriate cost of equity will be substantially greater than the cost of debt.
Hospitals need to measure their weighted average cost of capital (WACC).
WACC is the cost of long-term debt multiplied by the ratio of long-term debt to total capital plus the cost of equity multiplied by the ratio of equity to total capital (where total capital is the sum of long-term debt and equity).
WACC is then used as the basis for capital charges associated with all capital investments. Capital investments should be expected to generate positive returns after applying this capital charge based on the WACC. Capital investments that don’t generate returns exceeding the WACC consume enterprise value; those that generate returns exceeding WACC increase enterprise value.
Hospital executives need to be rewarded for increasing enterprise value.
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- FINANCE: Financial Planning for Physicians and Advisors
- INSURANCE: Risk Management and Insurance Strategies for Physicians and Advisors
- Dictionary of Health Economics and Finance
- Dictionary of Health Information Technology and Security
- Dictionary of Health Insurance and Managed Care