1 MHSA 8630 Health Care Financial Management Cost of Capital and Capital Structure Theory I. Corporate Cost of Capital ** Previous lectures have identified the two primary sources of long term capital financing utilized by organizations to purchase capital assets long term debt and equity capital. Examples of long term debt included bonds of various types (taxable, municipal) as well as term loans from financial intermediaries such as banks. Examples of equity financing included various forms of stock (preferred, common) and retained earnings. ** The vast majority of organizations typically utilize some mix of these two different sources of capital to purchase various fixed assets. The mix of capital employed by an organizational enterprise is referred to as that organization s capital structure, and can be identified readily by looking at the right hand portion of the organizational balance sheet, which is comprised of long term liabilities and owner equity. ** The use of each of these sources of capital financing imputes a cost on the organization. For long-term debt capital, the cost is imputed in the form of an interest rate or coupon rate on a bond. For equity capital, the cost is imputed in the form of dividends to stockholders and the more general opportunity cost of capital on retained earnings. ** The general process for estimating the cost of capital within an organization takes into account the specific types of capital financing utilized, the relative quantities of each utilized, and the relevant costs associated with each type. The most commonly utilized method for estimating cost of capital is known as the weighted average cost of capital (WACC) method, summarized as: WACC = [(w debt * R(R debt ) * (1-T)] * [(w equity * R(R equity )] ** In this formulation, the corporate cost of capital is estimated as the weighted average of each capital component s cost (debt, equity). This method assumes that the organization can specify an optimal capital structure (more on this later), and that this optimal structure will be reflected mathematically in the assigned weights (w debt, w equity ) utilized in the WACC estimation. For purposes of using this method, one need only additionally estimate the required rates of return on both the debt and equity capital components and incorporate the organization s tax status (taxable vs. tax exempt) to estimate the organization s cost of capital. This estimate tells organizational management how much it costs to utilize the various sources of capital to finance organizational assets.
2 ** WACC Component Estimation ** In terms of estimating the costs associated with various components of organizational capital, the focus should be on the cost of the next (or marginal) dollar of capital as opposed to estimating historical costs, unless historical costs are relevant to current costs. ** Cost of debt capital depends largely on the types of debt that will be utilized by the organization to finance capital assets. As seen before, there exists a variety of long-term debt instruments that may be utilized in various quantities for this purpose (mortgage loans, debentures, bonds, etc.). Depending on the selected forms of long-term debt, the cost may be estimated by the stated (coupon) rate of interest or the implied (yield to maturity) rate of interest. >> Stated rates of interest may be obtained from innumerable sources of information including financial periodicals, investment bankers, etc. Alternatively, cost of debt capital (especially for bonds) can be estimated by the current yield to maturity of outstanding bonds of the organization (or similar organizations), especially when the relative maturities of the different issues are roughly the same. ** The only difference at this point with respect to estimating cost of debt capital, using WACC, between investor-owned and not-forprofit organizations relates to the adjustment for the tax benefits of using debt capital in investor-owned organizations. Because investor-owned (taxable) organizations are allowed to deduct paid interest expenses from taxable income, it effectively reduces the cost of debt capital to such organizations by their marginal rate of taxation (T). The net after-tax cost of debt capital is thus estimated by multiplying the pre-tax interest expense by (1-T). ** Not-for-profit organizations also realize a cost of capital benefit from using debt capital, albeit indirectly. As was mentioned previously, not-for-profit organizations, as a result of their tax exempt status, qualify for tax exempt forms of capital financing including municipal bonds, charitable contributions, etc. In the case of municipal bond financing, such bonds typically pay interest that is exempt from all forms of taxation. As the after-tax rate is the same as the before-tax rate in this case, the required rate of return (interest) on such issues is typically a lot lower than the required rates of return on taxable bond issues of similar size/risk. ** Overall, the cost of debt capital between FP and NFP organizations of similar size and risk are roughly similar.
3 ** Cost of equity capital explicit and implied costs associated with the use of various sources of equity capital. Specifically, includes (1) the required rate of return on the organization s outstanding stock, as well as (2) the opportunity cost associated with the organization s use of retained earnings. >> Required rate of return on stock: the explicit cost imputed to the organization of raising equity capital through the sale of various forms of stock. Unlike the case of long-term debt financing, the returns on stock are not contractually guaranteed, and thus it follows that estimating the required rate of return (cost) on equity from stock is more difficult to estimate. In general, there are three (3) different methods commonly utilized to estimate the required rate of return (cost) of equity capital for stock (1) the CAPM method; (2) the discounted cash flow (DCF) method; (3) the debt cost plus risk premium method. ** CAPM method as illustrated previously, the CAPM can be used to estimate the required rate of return on a given investment (equity in this case) as follows: R(Ri) = RF + (RF - R(Rm))*Bi ** Where R(Ri) represents the required rate of return on investment i (stock), RF represents the risk free rate, R(Rm) represents the required rate of return for a well diversified portfolio of stocks, and Bi represents the beta value associated with investment (stock) i. ** Operationally, RF is estimated as the going rate of return on treasury bonds between years in maturity. Though not technically risk free due to the presence of interest rate risk, such investments have no default risk and are as close to risk free as one can get in terms of investment alternatives of similar maturity. Ideally, the maturity of the chosen RF benchmark should roughly coincide with the expected holding period of the stock. ** R(Rm) estimates the expected (and required) returns associated with a diversified portfolio of stocks under current market (equilibrium) conditions. Such values are typically derived from historical stock returns over extended time periods, the implication being that long-term historical returns on stocks should roughly predict future stock returns over extended periods of time. Such values can be obtained from many different sources.
4 ** The estimation of a stock s market beta value (Bi) describes how risky the returns of a particular stock are in relation to the returns on some average stock index. As before, a stock s beta can be estimated by regressing the historical returns on the stock against the returns associated with the chosen stock index. The estimated slope of this line represents the stock s market beta value. A number of different types of beta values can be estimated as part of this process, and the choice of market beta to utilize in the CAPM estimating process is a judgment call at best. ** Due to the uncertainties inherent in the estimation of several of the input variables to the CAPM model for estimating R(R equity ), especially the market beta values, it is typically the case that organizations will estimate a range of values for R(R equity) as opposed to a single value, and use this range of estimates to estimate a range of values for its corporate cost of capital as a result. ** DCF method using either the constant dividend growth or non-constant dividend growth model as a basis for estimating R(R equity ) associated with the sale of stock. This method, unlike the CAPM method, utilizes actual estimates of cash flows (dividends paid) over time to estimate the cost of equity (stock) capital as opposed to relying on various market return indices as in the CAPM. ** As discussed previously, at market equilibrium, the following equation can be utilized to estimate the required rate of return to stock investments (R(Re)): Do * [1 + E(g)] E(Re) = R(Re) = Po + E(g) ** Do is the most recent stock dividend paid, E(g) is the expected (constant) rate of dividend growth, Po is the most recent per share stock price listed. Information on current stock prices and most recent dividends paid can be readily obtained from various financial sources of information. ** Estimation of expected dividend growth rates (E(g)) is more difficult to accomplish due to the uncertainty surrounding the prediction of future events. Traditionally, such estimates were derived from either historical growth rate estimates, analysts forecasts, or from the use of an application known as the retention growth model.
5 ** Debt cost plus risk premium method estimates the cost of equity capital (in the form of stock) to the organization using the following mathematical identity: R(Re) = R(Rd) + equity (stock) risk premium ** Where R(Rd) represents the organization s estimated cost of debt capital, and the equity (stock) risk premium represents the AVERAGE difference between returns on stock and long term debt securities under a given set of market conditions. Historically, most equity risk premiums have been between four and seven percent, depending on the prevailing interest rates at a given point in time. (i.e. higher interest rates, lower equity risk premiums, and vice versa) >> Required rate of return on retained earnings/fund capital: unlike the case of R(Re) for stock, R(Re) for retained earnings or fund capital is relevant to the estimation of the corporate cost of capital in both investor-owned as well as not-for-profit organizations, as both types makes use of this source of equity capital (in the form of retained earnings) to purchase/finance capital assets. ** Although applicable to both FP and NFP organizations, the estimation of R(Re) for retained earnings/fund capital is by far the most conceptually challenging to accomplish for a number of reasons, primarily related to the lack of an explicit or defined cost of utilizing such forms of equity capital. Unlike the case of stocks and bonds, there is no well defined cost of capital associated with the use of retained earnings or fund capital more generally that can be used to estimate the corporate cost of capital. ** The most commonly utilized, though far from ideal, approaches to estimating R(Re) for retained earnings and/or fund capital within both investor-owned as well as not-forprofit organizations include (1) setting R(Re) equal to the expected rate of growth in the organization s fixed assets over time (replacement cost estimate); (2) setting R(Re) equal to the R(Re) associated with the stock of similar types of investor-owned organizations in terms of size and risk. (opportunity cost estimate of next-best alternative returns).
6 ** Interpretation of WACC estimate ** Once estimated from its various components, the WACC for an organization should reasonably measure the true opportunity cost to the organization of employing the various sources of capital funds to finance the purchase of capital assets for the purpose of generating organizational cash flow in the future. ** From a normative economic perspective, the assets that are purchased with these funds should earn the organization a return on investment that is at least as great (or greater) than the cost of the funds employed. Otherwise the organization would be better off, economically speaking, by using those funds to purchase other assets/investments that earn higher returns. ** From a purely financial management perspective, the WACC represents the hurdle rate of return that all potential new fixed asset investments must (potentially) meet in order to be considered as part of the capital budgeting process (more later). ** Also of note regarding the WACC estimate: (1) The WACC estimate(s) specify the MINIMUM required rate(s) of return on all new asset purchases/investments REGARDLESS of the actual capital mix employed the organization (% debt vs. % equity). This is because the WACC assumes a certain optimal capital structure that the organization pursues over the long run for the purpose of minimizing the opportunity cost of capital (more later). (2) The WACC estimate(s) specify the minimum required rate(s) of return only for fixed assets/investments of AVERAGE risk to the organization. For those assets or investments that are significantly riskier than average, the WACC estimate will tend to understate the actual required rate of return on such assets/investments. In this context, investment/asset risk can be comprised of business risk (risk associated with future cash flows from the investment/asset) and/or financial risk (risk associated with the level of debt capital assumed by the organization). (3) Factors that will influence the WACC estimate include interest rates (higher interest rates, higher WACC), tax rates (higher tax rates, lower WACC), capital structure policy (more later), and capital investment policy (effect of different asset risks on organizational risk and WACC).
7 II. Capital Structure Decisions ** Beyond the general mechanics involved with estimating the corporate cost of capital lies the larger issue related to the choice of capital structure employed by the organizational enterprise to finance the purchase of capital assets. ** As stated previously, the weighted average cost of capital approach to estimating the cost of capital assumes that the weights employed for both equity and debt capital incorporate the organization s optimal capital structure as part of the estimation process, regardless of the actual mix of each component utilized at any given point in time. ** It was not previously discussed how the optimal capital structure was derived/determined by the organization, nor were any other factors discussed that influenced organizational decision-making as it related to the choice of the optimal capital structure either. ** The fundamental question to be addressed as it relates to capital structure decision-making is whether or not there is a single optimal capital structure (debt vs. equity) that an organization should employ so as to finance the purchase of capital assets in such a way to maximize the value of the organizational enterprise as a whole. ** The choice of capital structure as it relates to the maximization of organizational value takes into consideration issues related to both organizational risk and return. ** In terms of returns for investor-owned organizations, the tax deductibility of paid interest expense on debt capital has the effect of (1) reducing taxable income, thereby increasing after-tax profits, and (2) increasing the returns to equity capital (ROE) for the organization. The leveraging up of ROE with the use of debt is consistent with increased returns from the use of debt capital. ** While financial returns to equity capital can be increased through the use of debt capital, it is also the case that increased use of debt capital will commensurately increase the financial risk borne by the organization. Interest expenses on debt capital are contractually fixed, and must be paid regardless of the organization s financial performance. This contractual requirement increases organizational financial risk by increasing the standard deviation of expected returns to equity (ROE) relative to equity capital alone, where dividend payments are not contractually guaranteed. The difference between the equity-only standard deviation from ROE (unleveraged) and the debt-equity standard deviation from ROE (leveraged) estimates the level of financial risk assumed by the organization.
8 ** Another element of organizational risk that is fundamental to decision making regarding capital structure is the inherent business risk associated with the organization s day-to-day operations. ** In a nutshell, business risk refers to the level of uncertainty associated with the organization s ability to generate sufficient cash flow over time to meet its contractual obligations, including the payment of interest expense of debt capital. In general, the more uncertain, or less predictable, an organization s cash flows from operations tend to be, the greater the level of business risk inherent to the organizational enterprise. The level of business risk assumed by an organization is independent of the level of debt it employs in its capital structure decision-making. ** External factors that are known to affect the level of business risk include variability in the demand for an organization s products or services, variability in market prices for the organization s goods or services, and variability in the cost of inputs. Internal factors that are known to affect the level of business risk include the ability of the organization to raise output prices and the degree of operating leverage employed by the organization (measure of fixed costs of production as a percentage of the total costs of production). It is presumed that the use of financial leverage (debt capital) along with operating leverage will work synergistically to increase both the ROE as well as the level of organizational risk. ** Presented once again with a classical risk/return tradeoff decision to be made regarding what level of debt capital, if any, to employ as part of the organization s optimal capital structure, decisions will be made based on a systematic assessment of both the risks (costs) and returns (benefits) associated with each level of debt capital employed. ** An overview of capital structure theory will assist in determining the relationship between the level of debt capital employed within the organization s capital structure and the overall value of the business, with the goal of ascertaining, after consideration of risk, whether the increased use of debt capital is beneficial or not. ** A number of capital structure theories and models have been developed for the purpose of explaining/predicting the relationship between the use of debt vs. equity financing and the overall value of the organization. The ones most commonly utilized for this purpose are collectively referred to as tradeoff models. These models, as developed by Modigliani and Miller and empirically tested by others, argue that an organization s optimal capital structure is achieved by balancing the tax-related benefits of debt financing against the financial distress costs associated with increasing use of debt capital.
9 ** The conceptual relationship between the use of debt capital and the value of the organizational enterprise, as described by these tradeoff models, is as follows: V L = V U + (T * D) - PV D ** Where V L represents the market value of the leveraged firm (i.e. one that uses at least some debt), V U represents the market value of the same firm without the use of any leverage (debt), T represents the firm s marginal tax rate, D represents the amount of debt capital employed by the firm, and PV D represents the present value of future financial distress costs associated with the use of a particular level of debt. ** The tradeoff models, and the associated mathematical identity implied by those models, are highly conceptual, and thus difficult to validate empirically. Furthermore, due to their conceptual nature, it is also difficult, if not impossible, to specify an optimal capital structure with any degree of precision. ** The implied relationship between the level of debt capital employed by the firm and its market value, according to the tradeoff models, is bimodal: the value of the firm is assumed to increase initially (due to the tax benefits of using debt vs. equity) as the unleveraged firm takes on some level of debt, up to some defined range or percentage of total capital where value is maximized; beyond this conceptual point, as debt increases even more, the tax benefits of higher levels of debt are subsumed by the conceptually larger costs associated with future financial distress, reducing the overall value of the firm from its maximum value. ** Another theory/model of capital structure that has been shown to have some explanatory power in relating capital structure decisions to actual financial performance of the firm is called the asymmetric information model. This model makes two assumptions about firm management that are crucial to its predictions: (1) the firm s managers know more about the future prospects of the business than investors in the firm do; (2) firm managers are motivated solely to maximize the wealth of the firm s current shareholders. ** Unlike the tradeoff models described previously, this model predicts that managers will alternatively choose completely different capital structures at different points in time rather than approach capital structure decision making in a more continuous, systematic manner. The reason for the divergence in predictions between the different models is related to the different objectives assumed under each (i.e. risk/return tradeoffs on level of debt financing under tradeoff models; shareholder wealth maximization under the asymmetric information model).
10 ** For example, the tradeoff models predict that the un-leveraged (100% equity) firm adds debt on a more or less continuous basis, up to the point where the tax advantages are equal to the expected costs due to financial distress, thereby maximizing the value of the firm. The asymmetric information model, however, suggests a pecking order in terms of firm capital preferences, with the highest preference assigned to retained earnings, followed by debt capital, followed lastly by new issues of equity in the form of stock (shareholder wealth maximization). ** Combining the tradeoff models with the asymmetric information model (with all of their associated implications), allows for the following generalizations about capital structure for investor-owned firms: (1) Debt financing provides benefits in the form of the tax deduction of interest expenses, and such deductions can, up to a point, increase the value of the firm by effectively reducing the corporate cost of capital. (2) Beyond some level of debt, which varies from firm to firm and industry to industry, the expected costs of financial distress completely offset (and ultimately subsume) the tax benefits associated with debt capital, increasing the corporate cost of capital as a result and reducing the value of the firm. (3) Due to the presence of information asymmetries between firm management and investors, businesses maintain a reserve borrowing capacity to draw upon when business prospects are good and/or the firm is currently undervalued by current/prospective equity investors. ** As it relates to not-for-profit organizations, it is generally reasonable to expect that many of the same issues faced by investor-owned entities related to choice of optimal capital structure will apply to NFP s as well, with the caveat that, due to their NFP/tax exempt status, such firm s do not have access to equity marketplaces and thus cannot issue stock like investor-owned/taxable organizations can. The lack of access to equity outside of retained earnings/fund capital leaves NFP s with far less flexibility in terms of capital structure choices than investor-owned organizations. ** This capital structure constraint effectively leaves the NFP with a choice between debt capital and retained earnings/fund capital. This limits their flexibility to such an extent that NFP s are more likely to delay new capital projects due to capital financing restrictions and are more likely to utilize a greater amount of debt capital than is theoretically optimal based on costs of financial distress associated with higher levels of leverage.
11 ** Capital Structure Decision Making ** Regardless of the organizational setting, there are a number of criteria that financial managers take into consideration when making decisions with respect to capital structure and specific sources of financial capital, including: ** Maintenance of long-term viability ** Managerial preferences for financial risk ** Lender/rating agency attitudes towards financial risk ** Degree of reserve borrowing capacity ** Industry benchmarks for financial risk ** Shareholder control issues ** Organizational asset structure/business risk ** Projected growth rate ** Projected profitability ** Organizational taxation