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A “Must-Know” Economic Concept for Not-for-Profit Hospital Executives
[By Calvin W. Wiese; MBA, CPA]
It is critical to understand and to measure the total cost of capital for any hospital or healthcare organization. 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.
Equity Cost
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 physician 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.
Equity Greater than Cost of Debt
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%; or lower recently. 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.
The Weighted Average Cost of Capital
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).
Assessment
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.
Conclusion
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Filed under: Career Development, CMP Program, Health Economics, Healthcare Finance, Investing | Tagged: Calvin Wiese, cost of hospital debt, david marcinko, equity costs, equity markets, equity public markets, not-for-profit hospitals, WACC, weighted average caost of capital, www.healthcarefinancials.com |
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Excellent Post,
Capital investment is fueled by profit. In order to continually make the necessary long term capital investments, hospitals must be profitable.
Hospitals unable to generate sufficient profit will fail to make important capital investments, weakening their ability to compete and survive.
Adam
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Football … on the ME-P?
Yep; its true!
Did you know that Giants quarterback Eli Manning — who has already raked in hundreds of thousands of dollars doing publicity for a Catholic Greenwich Village hospital in New York — has agreed to forgo future paychecks because of its fiscal straits?
Read more here: http://msn.foxsports.com/nfl/story/new-york-post-eli-manning-lets-hospital-out-of-contract-022410/?gt1=39002
Hope Rachel Hetico; RN, MHA
[Managing Editor]
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More on Non-Profit Hospitals
Section 501(c)(3) of the Internal Revenue Service (IRS) code requires that an exempt entity be organized and operated “exclusively” for exempt purposes. Regulations interpret this standard as requiring that exempt organizations engage “primarily in activities that accomplish one or more…exempt purposes.” If “more than an insubstantial” amount of the exempt organization’s activities does not further the purpose of the exempt organization, the standard is violated. Exempt organizations can engage in joint ventures with for-profit organizations. When a not-for-profit hospital enters into a joint venture with a for-profit medical group, the IRS states the focus should be on whether the arrangement serves a charitable purpose.
In 2004, the IRS implemented the Executive Compensation Compliance Initiative to review the compensation practices of public charities and private foundations. Many reporting errors and omissions were found through compliance check letters and examinations due to confusion about the instructions on Forms 990 and 990-PF. Then in 2006, the Government Accountability Office reported that of the 65 hospitals responding to a survey, 40 hospitals had written executive compensation criteria, with the majority of reporting hospitals having a committee that approved the CEO’s base salary, bonuses, and prerequisites. Examinations of 25 exempt organizations found excessive salary and incentive compensation, payment for vacation homes and personal automobiles, and payments for personal meals and gifts. Many organizations also incorrectly reported compensation on one or more forms.
In March 2007, the IRS reported that of the 1,826 tax-exempt organizations involved in its Executive Compliance Initiative, 782 audits were conducted and $21 million in excise taxes was levied against 40 individuals and 25 different organizations for engaging in excess benefits transactions. Several key issues were factors in causing these assessments including: excessive salary and incentive compensation; payments to an officer’s for-profit corporation in excess of the value of the services provided by the corporation; and, payments for personal legal fees, vacation homes and personal automobiles not reported as compensation. The report also indicated that loans to officers and other executives will be the subject of single-issue compliance checks and audits in the next phase of the IRS’s Executive Compliance Initiative.
In February 2010, the IRS began a payroll audit program of 6,000 companies, including an approximately 1,500 tax-exempt organizations, such as non-profit hospitals. The program primarily focuses on the misclassification of employee status, which can cost nearly $200 million annually in unemployment costs, and excessive executive compensation. The 2010 audits are part of an agency wide National Research Program (NRP) of employee tax reports, the purpose of which is to collect data to help the IRS target future employment tax audits. Additionally, companies that are found to have executive compensation plans and/or benefits exceeding Fair Market Value, according to the auditors, face strict application of the current codes sanctions. Such penalties include being subject to an excise tax and the possible revocation of an organization’s tax-exempt status.
In addition to the increased scrutiny of hospital executive compensation by the IRS, provisions in recently passed health care legislation will likely result in additional enforcement action taken against non-profit entities. Section 4959 of the “Patient Protection and Affordable Care Act” (ACA) calls for a mandatory review of the tax-exempt status of non-profit hospitals, focusing on the adequacy of their community benefit activities, the standard by which hospitals gain tax-exempt status subsequent to the removal of charity care requirements in 1969.
All investigative efforts by both state and federal agencies regarding executive compensation assist the IRS with insight into the procedures for setting executive salaries at tax exempt organizations and how to regulate these practices.
Robert James Cimasi MHA AVA ASA CMP™
http://www.HealthCapital.com
[via Ann Miller RN MHA]
http://www.amazon.com/Dictionary-Health-Economics-Finance-Marcinko/dp/0826102549/ref=sr_1_6?ie=UTF8&s=books&qid=1254413315&sr=1-6
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Not-for-profit hospitals in 2015
Stewardship is a term that aptly describes the responsibility borne by hospital managers in making capital investments. The New Testament parable of the talents describes this kind of stewardship.
In this story, a merchant entrusted three managers with money to invest. One manager was given five units, another two, and a third one. At the end of the investment period, the two managers given five units and two units reported a 100% return. The manager given one unit reported zero return — he was fired and his unit was given to the first manager.
This is stewardship — and hospital managers are stewards of their organizations’ assets.
Too often, not-for-profit hospital managers hold an erroneous view of the returns expected of them. Like the third manager in the parable, they think zero return on equity is acceptable. They understand capital investment funded by debt needs to cover the interest on the debt, but they view capital investments funded by equity as having no cost associated with the equity.
From an accounting perspective, they are right. From a stewardship perspective they are dead wrong — just like the third manager in the parable.
Hope R. Hetico RN MHA
http://www.amazon.com/Financial-Management-Strategies-Healthcare-Organizations/dp/1466558733/ref=sr_1_3?ie=UTF8&qid=1380743521&sr=8-3&keywords=david+marcinko
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