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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HEALTH TRACKING: MARKE TWAT C H the nonprofit hospital and our assumption price per procedure each hospital would have that it has a lower cost of equity financing to charge patients just to break even.At than the for profit hospital does. To isolate CMC's assumed cost of financing of 7.92 per he tax effect strictly, it is useful to calculate cent, that break-even price would be $666.At NPVs for the two hospitals on the assumption HCI's assumed higher cost of financing of that HCI's after-tax cost of debt is identical to 11.34 percent, that break-even price would be CMC's tax-exempt cost of debt and that $737, or 10.7 percent higher than CMC's HCI CMC's cost of equity capital is identical to would have to charge that differential to cover HCI's cost of equity capital Dn these assump p- its higher cost of financing and the income tions, the two hospitals would have the iden- taxes that it must pay but from which the tical WACC, which, for HCI, would be after nonprofit CMC is exempt taxes. Exhibit 2 shows the respective NPVs at To isolate how much that differential different assumed, common WACCs. As would be attributable strictly to the income shown in column 3 of the exhibits even if one tax preference enjoyed by CMC, one would imputed to the two hospitals the identical impute to both hospitals the identical WACC cost of financing, the not- for-profit CMC and then calculate the corresponding break would always have a decided economic ad- even prices(Exhibit 3). One can see that at vantage over the for-profit HCL. That advan- any assumed WACC, the for-profit hospital tage would be strictly the present value of the would have to charge much higher prices income-tax preference enjoyed by CMC merely to recoup its outlays on income taxes, Break-Even Prices a differential that rises with the assumed cost of financing. In reality, of course, for - profit When for-profit hospitals are found to charge hospitals pay not only income taxes but usu- higher prices for particular procedures than ally also higher property taxes than are paid nonprofit hospitals in the same market area by similarly situated nonprofit hospita harge, that is sometimes interpreted as price These higher taxes, too, would have to be re gouging by the for-profit hospital. It may be couped by the for-profit with higher prices oOn the other hand, as the preceding analy. other things being sis shows, it also could be an attempt by the A variety of loopholes available to corpora- for-profit hospital to compensate for its rela- tions can reduce the effective average tax rates tive economic disadvantage vis-a-vis its tax- they pay below the statutory rate of 35 per favored, nonprofit competitors cent. That circumstance, however, would al- To gain some perspective on this point, I ter the evaluation of a particular capital acqui recast the preceding analysis to inquire what sition only if these loopholes also shielded the EXHIBIT 2 Net Present Values(NPVs) At Common Cost-Of-Capital Rates For Two Hospitals, HCI And cMc Assumed cost NPV from the for-profit NPv from the nonprofit Extra NPv earned by of financing HcI's perspective CMC,s perspective the nonprofit hospltal $484,193 $433,655 9 percent 63000 351,341 414,341 10 percent 171,493 224,603 396095 11 percen 275,228 103622 378850 12 percent -374,476 11,935 13 percen 469,485 122,377 347108 14 percent 560.49o -227993 15 percent -647,710 329.052 318,658 SoURCE: Authors analysis. HEALTH A S bcr/D Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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H LTH TRACKING MARKETWATCH EXHIBIT 3 Break-Even Prices Per Procedure For Two Hospitals, HCl And CMc Break-even price Cost of financing For-profit HCI Nonprofit CMC Hcl as percent of CMc 104.4% 720 683 105.4 12 percent 14 percent 772 719 SOURCE: A net operating income on the incremental op- exempt debt financing therefore does not call erating cash flow expected from that particu- for compensation by the nonprofit hospital lar project. On the other hand, if one compares Matters are more complicated in connec he overall economic advantage enjoyed by a tion with equity capital. Suppose a for-profit nonprofit firm as a whole over a similarly situ- and a nonprofit hospital used the same total ated for-profit firm as a whole a lower effec- amount of capital assets and maintained the ive average income-tax rate would narrow same debt/equity mix in financing those as the nonprofit's overall economic advantage sets. Each therefore would have the same over for-profit hospitals commensurately amount of equity capital invested in hospital Policy Implications Suppose the for-profit hospital earns for the suppliers of its equity capital an annual If one accepts the common textbook proposi- monetary return of s15 per $100 of that equity tion that, in principle, the social obligation of capital. That return does go to society at large, an investor-owned business firm is merely to because the suppliers of the firms equity maximize the wealth of its owners, without capital are members of society(although not violating the laws of the land, then it follows necessarily members of the particular com that a for-profit hospital does not, in princi- munity in which the hospital is located ).As ple, owe society any unrequited community noted earlier, that monetary return must services of any kind. With that proposition cover the shareholders'opportunity costs of as a baseline, the question then arises what investing their fund in a risk-free asset(fo extra benefits nonprofit hospitals owe society example, a U.S. Treasury bond), plus a pre in return for the relative economic advantage mium for the risk the owners assume by en society grants them vis-a-vis similarly situ- trusting their funds to this particular for ated for-profit hospitals, These benefits could profit hospital take the form of unrequited community serv Given this baseline, the question arises ices or of lower prices than those charged by what returns the nonprofit hospital ought to similarly situated for- profit hospitals for the achieve with the equity capital it has invested same services. In thinking about this ques- in its assets. Because the nonprofit hospital tion, one should distingu learly between cannot profits to the suppliers the various sources of that adv of its equity capital, it can pay the expec Cost of financing. As noted earlier, the returns in only two forms: either in enhanced ability of nonprofit hospitals to raise debt in retained profits, or in community bene the tax-exempt bond market does not really that are valued by society but for which so bestow on them a significant economic ety will not pay explicitly. It may vantage, because on an after-tax basis the cost that to match the returns that the for profit of debt financing is roughly the same for non- hospital earns for society at large on equity profit as it is for for-profit entities. Tax HEALTH AFFAIRS VoIume 9 nu r 5 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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H EALT MARKET WAT C H financed assets, the sum of profits retained by which, it can be said, "already gave at the tax the hospital and the monetary equivalent of office the unrequited community benefits it pro Granted, implementation of the normative vides the community should be equal to the standard proposed here would be complex in monetary rate of return that for-profit hospi- practice. However, if it were accomplished. tals earn for their suppliers of equity capital. we probably would find that many nonprofits On our assumptions in this illustration, that in our society already pass this standard with would be at least $15 per $100 of equity capi- flying colors. Many others, however, might tal invested in assets. This argument would not Be that as it may, a first practical step in rely on the common-sense proposition that extracting more formal accountability from under an efficient allocation of society's scarce the nonprofit sector for the tax advantages its resources. these resources members use might be to levy should yield society roughly Economic initially the same set of taxes the same benefits per dollar of ofit resource committed, regardless efficiency ought corporate health care facilities of their ular applie o be Both of hospitals the That propo sition, however could be allowed to treat as a implicitly equates the esti- pursued blithely in dollar-for-dollar tax offset the mated dollar value of the com auditable and certifiable munity benefits provided by abstraction from monetary estimate of the value nonprofit hospitals with the distributional of uncompensated community dollar returns earned by the benefits that they have ren shareholders of for-profit hos dered during a given fiscal pe pitals. To the extent that these riod. The value of charity or 185 distinct types of returns accrue to distinct uncompensated care, for example, could be groups in society, the proposition may ab- set at rates established by Medicare. For other stract unduly from the incidence of these benefits the valuation would be more com benefits. To many champions of the nonprofit plex. It would be altogether healthy, however, sector, it will not be obvious that S100 worth to explore more formally just what the value of community benefits rendered to poor, un- of those community benefits rendered by non- insured patients can be equated with $100 profit entities might be, and how many of worth of monetary benefits bestowed on the them society wishes to purchase indirectly often wealthy shareholders of a business cor- through its tax system. It is difficult to see poration. 4 I, for one, have great sympathy how anyone could object to this form of ac with that argument, for economic efficiency countability in our democracy ought never to be pursued blithely in abstrac tion from distributional effects. Taking into account distributional effects. however makes determining the proper amount of community benefits owed by nonprofit hospi tals an inherently political issue Tax preference. As was shown in the preceding analysis, there can be no doubt that the tax exemption enjoyed by not- for- profit hospitals is an economic advantage. It seems reasonable to argue that in return for this tax preference, nonprofit institutions owe society more uncompensated community benefits(or lower prices) than do for-profit hospitals, HEALT HAFFAIRS 2000 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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HEALTH TRACKING MAR WAT CH NOTES stocks"systematic risk"is measured empirically 1. G. Claxton et al., "Public Policy Issues in Non (and highly imperfectly)by the so-called beta rofit Conversions: An Overview, Health Affo coefficient of the stock (Mar/Apr1997):13 The formal theory underlying this construct is 2. B Gray, " Conversion of HMOs and Hospit the Capital Asset Pricing Model. See, for exam- What's at Stake?"Health Affairs(Mar/Apr 199 e, R.A. Brealey and S.C. Myers, Principles of Cor- porate Finance(New York: McGraw Hill, 2000) 3. See U.E. Reinhardt, "The Rise and Fall of the Physician Practice Management Industry, l1. See L.C. Gapenski, Understanding Health Care Fi Health Affairs (an/Feb 2000): 42-55 nancial Management(Ann Arbor, Mich: AUPHA 4. Although depreciation expense is deducted from Press/Health Administration Press. 1993), chap revenues in calculating accounting income, de 8. By this reasoning, funds donated for and there- preciation is a noncash expense calculated by fore restricted to a particular philanthropic pur- accountants to allocate the cost of long-lived as- pose would have a zero cost of capital, because sets to several accounting periods. Depreciation they do not have an opportunity cost expense enters a capital-budgeting analysis only 12. The details of this analysis are available from the insofar as it shields income from taxation author at thereby preventing an outflow of cash to the gov- 13. Political constraints and public relations may ernment nevertheless make it profitable for the for profit 5. In this exercise we use the Modified Accelerated hospital to be seen rendering some unrequited Cost Recovery System(MACRS)depreciation community benefits y in use. 14. Although about half of American households 6. To illustrate, if the incremental cash operating now directly or indirectly own common stock.it ncome due one year after the acquisition were $I is well known that the bulk of common stock in million and the weighted average cost of capital this country is owned by only a small minority of (WACC) were 10 percent, the ealthy households. In this connection, see E N value equivalent of that cash flow would be Wolff, "Why Stocks Won't Save the Middle 186 $1,000,000/1.10=$909, 090. If the corresponding Class"(Unpublished paper. New York Univer- cash flow three years hence were sI million as sity, 25 March 1999) well, its present-value equivalent would be 15. See U.E. Reinhardt, "Abstracting from Distribu s1000,0o01.103=S751,315 tional Effects, This Policy Is Efficient, in Health 7. Because of flotation costs, the cost of equity pro- Care and Health Economics, ed. M.I. Barer, T E cured via newly issued stock certificates is actu Getzen,and G L Stoddard (New York: Wiley, ally slightly higher than the cost of equity capital 1998),1-52 procured simply by retaining earnings. We ig nore that fine point here 8. Issuing and selling new stock certificates in olves flotation costs that are avoided when ee uity financing is procured through retained earn ings. Therefore, in theory, the cost of retained arnings is somewhat lower than that of equity procured via a new stock issue. For the sake of simplicity, we ignore this fine point, as do many 9. Phac titioners in the field uncertainty surrounding the returns to shareholders can be broken down into two com- ponents: variability that is systematically related to general market conditions (the stock's"sys tematic"risk), and variability unique to the firm in question(the stocks"unsystematic"risk). It can be demonstrated with modern portfolio the ory that a well-diversified portfolio of fifty tocks or more will eliminate from the investors perspective virtually the entire"unsystematic risk inherent in common stocks. Thus the risk for which an efficient stock market rewards the ivestor is only the"systematic, "market-related risk that cannot be eliminated through portfolio diversification. In practice, the magnitude of a H EALTHAFFAIRS voIu me 19. nu mbe r 6 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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