UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Fifth Edition
AUPHA HAP
Editorial Board
Leonard Friedman, Ph.D., Chair
Oregon State University
G.
... [Show More] Ross Baker, Ph.D.
University of Toronto
Caryl Carpenter, Ph.D.
Widener University
(2
Barry Greene, Ph.D.
University of Iowa
Richard S. Kurz, Ph.D.
Saint Louis University
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Sarah B. Laditka, Ph.D.
University of South Carolina
Stephen S. Mick, Ph.D., CHE
Virginia Commonwealth University (2
Michael A. Morrisey, Ph.D.
University of Alabama-Birmingham
Peter C. Olden, Ph.D.
University of Scranton
Janet E. Porter, Ph.D.
Dana-Farber Cancer Institute
Sandra Potthoff, Ph.D.
University of Minnesota
Lydia M. Reed
AUPHA
Sharon B. Schweikhart, Ph.D.
The Ohio State University
Nancy H. Shanks, Ph.D.
Metropolitan State College of Denver
Dean G. Smith, Ph.D.
University of Michigan
UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT
Fifth Edition
P
Louis C. Gapenski
In Collaboration with George H. Pink
Health Administration Press, Chicago, Illinois AUPHA, Washington, DC
AUPHA HAP
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The statements and opinions contained in this book are strictly those of the author(s) and (4
do not represent the official positions of the American College of Healthcare Executives, of the Foundation of the American College of Healthcare Executives, or of the Association of University Programs in Health Administration.
Copyright © 2007 by the Foundation of the American College of Healthcare Executives.
Printed in the United States of America. All rights reserved. This book or parts thereof may
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not be reproduced in any form without written permission of the publisher. Opinions and views expressed in this book are those of the author and do not necessarily reflect those of the Foundation of the American College of Healthcare Executives or the Association of University Programs in Health Administration.
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The paper used in this publication meets the minimum requirements of American National Standards for Information Sciences—Permanence of Paper for Printed Library Materials, ANSI Z39.48–1984. Ⓧ∞ ™
Library of Congress Cataloging-in-Publication Data
Gapenski, Louis C.
Understanding healthcare financial management / Louis C. Gapenski. — 5th ed.
p. cm.
Includes bibliographical references and index. ISBN-13: 978-1-56793-264-5
ISBN-10: 1-56793-264-9 (alk. paper)
1. Health facilities—Business management. 2. Health facilities—United States—Business management. 3. Medical care—United States—Finance. 4. Health services administration—Economic aspects—United States. I. Title.
RA971.3.G37 2006
362.11068'1—dc21 2006049050
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Health Administration Press A division of the Foundation of the American College of
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BRIEF CONTENTS
Preface xiii
PART I The Healthcare Environment
1 Introduction to Healthcare Financial Management 3
Pg
2 The Third-Party-Payer System 41
PART II Basic Financial Management Concepts
3 Time Value Analysis 79
4 Financial Risk and Required Return 115
PART III Capital Acquisition
5 Debt Financing 153
6 Equity Financing and Investment Banking 191
7 Securities Valuation, Market Efficiency, and Debt Refunding 221
8 Lease Financing 261
PART IV Cost of Capital and Capital Structure
9 Cost of Capital 293
10 Capital Structure Decisions 333
PART V Capital Allocation
11 The Basics of Capital Budgeting 377
12 Project Risk Analysis 423
PART VI Financial Condition Analysis and Forecasting
13 Financial Condition Analysis 463
14 Financial Forecasting 501
(2
PART VII Other Topics
15 Working Capital Management 539
16 Business Valuation, Mergers, and Acquisitions 575
17 Capitation, Rate Setting, and Risk Sharing 613
234.8
18 Financial Risk Management ............................... 647 (2
Glossary 679
Index 697
About the Authors 715
DETAILED CONTENTS
Preface xiii
PART I The Healthcare Environment
1 Introduction to Healthcare Financial Management 3
The Role of Financial Management in the Health Services Industry, 6; Current Challenges, 8; Alternative Forms of Business Organization, 8; Hybrid Forms of Organization, 11; Alternative Forms of
Ownership, 13; Organizational Structures, 17; Organizational
Goals, 20; Tax Laws, 24; Depreciation, 32
2 The Third-Party-Payer System 41
Insurance Concepts, 42; Generic Reimbursement Methods, 49; Major Health Insurers (Third-Party Payers), 56; Other Issues, 69
PART II Basic Financial Management Concepts
3 Time Value Analysis 79
Time Lines, 80; Future Value of a Lump Sum (Compounding), 81; Present Value of a Lump Sum (Discounting), 87; Opportunity Costs, 90; Solving for Interest Rate and Time, 92; Annuities, 94; Perpetuities, 99; Uneven Cash Flow Streams, 100; Using Time Value
Analysis to Measure ROI, 102; Semiannual and Other Compounding Periods, 105; A Review of Interest Rate Types, 110
4 Financial Risk and Required Return 115
The Many Faces of Financial Risk, 115; Introduction to Financial Risk, 116; Portfolio Risk and Return, 124; Portfolio Risk of Business
Investments, 133; Portfolio Risk of Stocks (Entire Businesses), 139; Portfolio Betas, 140; Relevance of the Risk Measures, 141; Interpretation of the Risk Measures, 143; The Relationship Between Risk and Return, 143; Some Thoughts About Beta and the CAPM, 147
PART III Capital Acquisition
5 Debt Financing 153
The Cost of Money, 153; Interest Rate Levels, 155; Long-Term Debt, 156; Term Loans, 157; Bonds, 158; Short-Term Debt, 163;
Debt Contracts, 169; Credit Ratings, 171; Credit Enhancement, 174; (4
Interest Rate Components, 175; The Term Structure of Interest
Rates, 180; Economic Factors That Influence Interest Rate Levels, 182; Advantages and Disadvantages of Debt Financing, 184
6 Equity Financing and Investment Banking 191
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Preferred Stock, 191; Rights and Privileges of Common P
Stockholders, 194; Classified Stock, 197; Selling New Common
Stock, 198; The Decision to Go Public, 203; The Decision to List, 205;
Advantages and Disadvantages of Common Stock Financing, 206; (4
Securities Regulation and the Investment Banking Process, 207; Equity in Not-for-Profit Firms, 214
7 Securities Valuation, Market Efficiency, and Debt Refunding . . 221
The General Valuation Model, 222; Debt Valuation, 223; Preferred Stock Valuation, 236; Common Stock Valuation, 237; Security Market Equilibrium, 247; Informational Efficiency, 248; The Risk/Return Trade-off, 251; Debt Refunding, 252
8 Lease Financing 261
Lease Parties and Types, 261; Tax Effects, 264; Financial Statement Effects, 266; Evaluation by the Lessee, 269; Evaluation by the Lessor, 277; Lease Analysis Symmetry, 279; Setting the Lease Payment, 280; Leveraged Leases, 280; Motivations for Leasing, 282;
Additional Issues, 285
PART IV Cost of Capital and Capital Structure
9 Cost of Capital 293
Overview of the Cost of Capital Estimation Process, 293; Estimating the Cost of Debt, 295; Estimating the Cost of Equity to Large
Investor-Owned Businesses, 298; Estimating the Cost of Equity to Not-for-Profit Businesses, 311; Estimating the Corporate Cost of Capital, 316; An Economic Interpretation of the Corporate Cost of Capital, 318; Flotation Costs, 321; Divisional Costs of Capital, 322;
Warning! Warning! Warning!, 323; Cost of Capital Estimation for Small Businesses, 324; Factors That Influence a Business’s Cost of
Capital, 327
10 Capital Structure Decisions 333
Impact of Debt Financing on Risk and Return, 334; Business and Financial Risk, 337; Capital Structure Theory, 341; Criticisms of the MM and Miller Models, 350; Financial Distress Costs, 351; Trade-off Models, 352; Asymmetric Information Model of Capital Structure, 355; A Summary of the Capital Structure Models, 357; Application of Capital Structure Theory to Not-for-Profit Firms, 359; Making the Capital Structure Decision, 361; Capital Structure Decisions for Small Investor-Owned Businesses, 364; The Debt Maturity Decision, 365
PART V Capital Allocation
11 The Basics of Capital Budgeting 377
Project Classifications, 378; The Role of Financial Analysis in Health Services Capital Budgeting, 379; Overview of Capital Budgeting Financial Analysis, 380; Cash Flow Estimation, 381; Cash Flow Estimation Example, 389; Breakeven Analysis, 397; Return on Investment Analysis, 399; Some Final Thoughts on Breakeven and Profitability Analysis, 405; Evaluating Projects with Unequal Lives, 406; Economic Life Versus Physical Life (Abandonment Value), 410; Capital Budgeting in Not-for-Profit Businesses, 412; The Post-Audit, 416; Using Capital Budgeting Techniques in Other Contexts, 416
12 Project Risk Analysis 423
Types of Project Risk, 424; Relationships Among Stand-Alone, Corporate, and Market Risks, 425; Risk Analysis Illustration, 427; Sensitivity Analysis, 429; Scenario Analysis, 432; Monte Carlo Simulation, 435; Qualitative Risk Assessment, 438; Incorporating Risk into the Decision Process, 439; Final Risk Assessment and Incorporation for the MRI Project, 442; Incorporating Debt Capacity
into the Decision Process, 443; Adjusting Cash Outflows for Risk, 444; Real (Managerial) Options, 446; The Real Option of Abandonment, 449; An Overview of the Capital Budgeting Decision Process, 453; Capital Rationing, 455
PART VI Financial Condition Analysis and Forecasting
13 Financial Condition Analysis 463
Financial Reporting in the Health Services Industry, 464; Financial Statement Analysis, 470; Ratio Analysis, 470; Tying the Ratios Together: Du Pont Analysis, 481; Common Size Analysis, 483; Percentage Change Analysis, 484; Operating Indicator Analysis, 485; Limitations of Financial Statement and Operating Indicator
Analyses, 489; Economic Value Added, 491; Benchmarking, 492; Key Performance Indicators and Dashboards, 494
(
14 Financial Forecasting 501
Strategic Planning, 501; Operational Planning, 504; Financial
Planning, 504; Revenue Forecasts, 507; Creating Forecasted Financial
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Statements, 510; Constant Growth Forecasting, 511; Factors That Influence the External Financing Requirement, 517; Problems with the Constant Growth Approach, 520; Real-World Forecasting, 521; Computerized Financial Forecasting Models, 525; Financial
Controls, 526; The Cash Budget, 527 (
PART VII Other Topics
15 Working Capital Management 539
Cash Management, 540; Marketable Securities Management, 544; Long-Term Securities Management, 546; Receivables Management, 547; Credit Policy, 553; Supply Chain
Management, 556; The Economic Ordering Quantity Model, 559; Accruals, 563; Accounts Payable (Trade Credit), 564
16 Business Valuation, Mergers, and Acquisitions 575
Level of Merger Activity, 575; Motives for Mergers: The Good, the Bad, and the Ugly, 578; Types of Mergers, 582; Hostile Versus Friendly Takeovers, 583; Merger Regulation, 584; Mergers Involving
Not-for-Profit Businesses, 588; Business Valuation, 590; Unique Problems in Valuing Small Businesses, 596; Setting the Bid Price, 598; Structuring the Takeover Bid, 600; Due Diligence Analysis, 602; The Role of Investment Bankers, 602; Who Wins? The Empirical Evidence, 604; Corporate Alliances, 606; Goodwill, 607
17 Capitation, Rate Setting, and Risk Sharing 613
An Overview of Capitation, 614; Provider Incentives Under
Capitation, 615; Financial Risk Under Capitation, 617; Development of Premium Rates, 626; Risk-Sharing Arrangements, 634
18 Financial Risk Management 647
Fundamentals of Financial Risk Management, 648; Risk Management of Capitated Contracts, 651; Debt Portfolio Immunization, 657; An Overview of Derivatives, 661; Options, 663; Futures, 668; Swaps, 671; The Use and Misuse of Derivatives, 673
Glossary 679
Index 697 P
About the Authors 715
(
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PREFACE
fter years of teaching corporate finance and writing related textbooks and casebooks, I began teaching the healthcare financial management course in the University of Florida’s Graduate Program in Health and Hospital Administration. The first thing that struck me was that no textbook was available that truly focused on healthcare financial management. To me, financial management primarily involves analysis and decision making, yet the textbooks available at the time mostly covered accounting and institutional detail, with only a very limited number of pages devoted to financial manage-
ment.
Thus, I set about creating a textbook that emphasized (1) financial management rather than accounting and (2) analysis and decision making rather than institutional detail. In creating this textbook, I set out to do two things. First, I adopted a very broad definition of the health services industry that included medical practices, managed care organizations, nursing homes, and home health care providers, in addition to hospitals. Today, more and more health services administration students are electing careers outside the hospital industry, and it is important that a textbook on healthcare financial management presents a broad range of provider settings. Second, I identified the environmental factors that are unique to the health services industry and hence make healthcare financial management different from corporate finance. Then, I made sure that these factors played an important role in the textbook discussions.
Concept of the Textbook
My goals in writing the first edition were to create a textbook that provided health services administration students with (1) an operational knowledge of financial management theory and concepts, (2) the opportunity to apply these ideas to real-world healthcare business settings, and (3) the opportunity to use spreadsheet analyses to help make better financial decisions. Additionally, I wanted to create a textbook that could be used as a reference during intern- ships and residencies as well as after graduation. Finally, I wanted a textbook
that students would find user friendly, meaning one that they would enjoy xiii
reading and could learn from on their own. If students don’t find a textbook interesting, understandable, and useful, they won’t read it!
This fifth edition of the textbook continues to meet those goals. It be- gins with basic concepts about both the health services industry and financial management. The textbook then progresses to show how financial manage- ment theory and concepts can be applied to healthcare businesses to help managers make better decisions, where “better” is defined as promoting the financial well-being of the organization.
Intended Market and Use
The textbook is targeted for the healthcare financial management course (
required in graduate programs in health services administration. Students typically have some background in basic business topics such as financial and managerial accounting, probability and statistics, spreadsheet analysis, and perhaps even corporate finance. However, the textbook contains a great deal of background information in these areas, and it can be used in programs where students have not had prior exposure to business topics. The textbook is useful also to healthcare professionals, including both those holding general management positions and those working as members of financial staffs [Show Less]