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 <reinhard@ princeton. ecu> 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 If the corresponding Class"(Unpublished paper.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 permissionReproduced with permission of the copyright owner. Further reproduction prohibited without permission