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CHAPTER
13
External Financing. Sources
Learning Objectives
After reading this chapter, the student should be able to:
1.	List the choices for external financing faced by health care organizations.
Explain the requirements placed on the organization by each external financing option.
3.	Discuss the issues involved in optimal capital structure decisions.

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Key Terms
Bankruptcy costs	Mortgage bond
Capital structure	Pecking order theory
Common stock	Preferred stock
Debenture	Senior
Free cash flow	Tax-exempt revenue bonds General obligation bond
Hospital revenue bond
Those who have read the previous chapters understand much about how financial markets work and about how the external financial environment, by determining the cost of capital, influences the decisions of health care organizations. The costs of debt and equity (and the returns that are possible from investing the organization's own assets in debt and equity) influence what projects can be undertaken (by affecting the discount rate in capital budgeting) and, therefore, influence the very nature of the services that can be provided. The Capital Asset Pricing Model, discussed in Chapter 9, forms the basis for understanding the financial market's assessment of risk and its expectation of return.
Many issues remain unexplored, however. Among them are (1) how an organization can go about tapping the financial market, (2) with whom it must deal in that market, (3) what financing alternatives are available, (4) how to decide among those financing alternatives, and (5) what the experiences of other health care organizations have been in obtaining external funds. This chapter and the two that follow deal with these interrelated questions. After completing Chapter 13, the reader should be able to discuss the natures of equity and debt financing, to describe their advantages and disadvantages, and to design an optimal capital structure.

EXTERNAL FINANCING: KEY TO SUCCESS
In the 1980s large health care organizations experienced the need for external capital as never before. Funding for hospital construction under the Hill-Burton Act had lapsed. The need for capital financing had increased with the developments of new, effective, but very expensive, technologies (such as CAT scanning, MRI,
organ transplantation, and lithotripsy). Cohodes & Kinkead (1984, p. 48) wrote that access to external financing was a key element in organizational success, and, in fact, in organizational survival. To respond to their needs for external financing, many organizations sold securities.

EXTERNAL FINANCING:THE CHOICES
The organization that decides to seek funds by selling securities has a multitude of alternatives from which to choose. Although all of those alternatives will provide

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cash for the organization, each brings with it a unique right-hand-side entry on the balance sheet and a unique obligation to the provider of funds. Figure 13—1 shows the major types of securities that one might consider selling to raise external funds. Note that not every alternative is available to every organization.
Investor-owned organizations can issue equity securities, raising external financing and imposing a particular type of obligation on the organization. The holders of common stock securities have no legal claim to an annual dividend, making common stock financing the least obligating form of external financing in terms of required cash flow. Equity holders, however, are the owners of the organization. They have a residual claim, the ownership of all that is left over after other suppliers of funds are paid off. Common stock holders almost always have a voice in the governance of the organization as well, although holders of small percent-ages of equity may be unable to exercise their voices effectively. Issuing common stock, then, is quite safe in terms of required cash payments, but quite risky in terms of possible dilution of ownership, claim on future profits, and loss of control. Common stock finance also requires a higher cost of capital than does any other type of financing. That cost of capital is masked by the fact that corporations need pay no annual dividend to common stock holders. Those stock holders, however, stand behind all debt holders and preferred stock holders in their claims against

Figure 13-1 External financing alternatives.

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the firm (they own what is left over). In financial distress, debt holders are entitled to their claim in full (they seldom receive payment in full) before common stock holders receive anything. Because investors view it as risky, due to its low seniority of payment, stock holders demand higher total returns than do debt holders, and, failing to receive it, sell their shares.
Preferred stock is senior to common stock in that its holders must receive their dividends prior to any dividends' being paid to the holders of common stock. The purchasers of preferred stock are entitled to a fixed annual dividend in perpetuity. Usually, preferred stock holders either have no voting rights or have voting rights only when their dividends are not paid. Preferred stock is like a debt security in
the fixity of its required payment. It is not, however, debt in the legal sense, and the payments made to its holders are, legally, dividends, not interest. Thus preferred stock is a desirable asset for taxable corporations, which can exclude a large percentage (varying with the degree of ownership held in the issuing corporation) of their dividend income from corporate income tax liability. Investors view preferred stock as less risky than the same firm's common stock but riskier than that firm's debt. Because of the tax exclusion of preferred stock dividends, however, the cost of capital for preferred stock financing is usually lower than the cost of capital for most debt financing.
Both not-for-profit and investor-owned organizations can obtain external financing by issuing debt. Not-for-profit organizations are limited in their external financing activities in that they can acquire external financing only by taking on debt. Investor owned organizations often prefer debt financing to equity financing. The claims of debt holders are always senior to those of equity holders. Taking on debt does not dilute the ownership of the organization. It does, however, obligate the organization to disburse cash to the lenders on the schedule specified in the loan contract (or the bond's trust agreement).
In the health care sector, government/nonfederal and not-for-profit organizations have the advantage of being able to obtain funding through the issuance of tax-exempt revenue bonds (Feldstein & Fabozzi, 1991). In every state, properly constituted units of government (in some states, a state financing authority; in others, cities and counties; and in others, special hospital districts) can issue bonds promising the holder interest backed by the revenues of specific not-for-profit and public providers. That interest, subject to a variety of restrictions and regulations, is not subject to federal income taxation for the recipient. In most states, the interest is not subject to state income taxation, if the bond is issued in the state in which the bond holder resides.
Because these bonds pay interest that is not subject to federal (and usually state) income tax, tax-paying investors are willing to accept lower rates of interest on them than they would on otherwise equivalent taxable bonds. Specifically, the equilibrium interest rate on a municipal bond (rm) will be

where rc is the rate of interest on an otherwise equivalent (same term to maturity, liquidity, and risk) corporate bond, and Tp is the tax rate of the investor at the mar-

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gin. Government/nonfederal and not-for-profit health care providers should exploit every opportunity to gain tax-exempt financing before they attempt to obtain financing at taxable interest rates (either through issuing bonds paying tax-able interest or through taking on bank debt).
There is debt and there is debt. Not all debt holders stand in equal seniority in terms of receipt of payments. Debentures are unsecured bonds, bonds not backed by any specific asset. Mortgage bonds are backed by claims on specific assets. Mortgage bonds are senior to debentures.
In the government and not-for-profit arena, bonds backed by the full faith and credit of a unit of government (general obligations bonds) are backed by the taxing power of the issuer. Hospital revenue bonds, on the other hand, are backed only by the revenues of the organization for which the bonds were issued. General obligation bonds, then, carry less risk for their holders but more risk for their issuers than hospital revenue bonds.
THE WEIGHTED AVERAGE COST OF CAPITAL ONCE AGAIN
Chapter 10 briefly discussed the weighted average cost of capital (WACC) in the context of selecting the appropriate discount rate in capital budgeting. The WACC is simply the average cost (in percentage terms) of a dollar of new financing for the organization, given some target mix of debt and equity financing. If an investor-owned firm were completely financed with equity (if it had no debt whatsoever), its WACC would be its cost of equity. As the share of debt financing in the organization's capital structure rises, the cost of debt becomes more important in its overall WACC.
The formula for WACC is

where We, Wd,1-t, and Wd,s-t are the weights (percentages of financing) of equity, long-term debt, and short-term debt, respectively. Those weights should be based on the market values of securities outstanding, not on the values recorded in the firm's books.
re, rd,1-t , and rd,s-t' are the relevant costs, expressed as percentages, of equity, long-term debt, and short-term debt, respectively. The costs of long-term and short-term debt are adjusted for the tax-deductibility of interest payments. If rd,1-t is the before-tax (nominal) cost of long-term debt, then the after-tax cost of long-term debt is

where Te is the firm's marginal tax rate.
When the weights used to compute WACC reflect the values of the securities currently outstanding, WACC reflects the current cost of capital. When the weights reflect a target capital structure that is different from the current capital structure, WACC reflects the cost of new financing.

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DEBT AND EQUITY CHOICES:THE CAPITAL STRUCTURE DECISION IN THEORY
Students of finance have puzzled over capital structure for a long time (Myers, 1984). Capital structure is the mix of debt and equity that finances the organization. Every organization, except those financed purely by annual government appropriations, must make choices about capital structure. Given a certain level of net assets (equity), the managers of government-owned organizations must decide whether increasing their level of debt (taking out a bank loan, for example) would increase their debt/equity ratio too much. This section will show that "too much" debt is a very murky concept indeed.
Recall, from Chapter 4, that capital structure can be measured by any of several ratios, including the debt/equity ratio, the asset/equity ratio, and the equity financing ratio. Those financial statement measures take accounting values into account. In the analysis in this chapter, the mix of debt and equity should be understood to refer to market values (the current value of equity and debt securities in financial markets) rather than to accounting values.
Prior to about 1960, textbooks in financial management agreed that there was an optimal capital structure and that every corporation could identify it and adjust its financing percentages accordingly. That capital structure was the one that minimized the weighted average cost of capital and that therefore maximized the value of the organization (the value of the organization being the sum of all future cash flows discounted at the weighted average cost of capital). Figure 13—2 is a picture of that view of the world.
The logic behind the pre-1960 view of optimal capital structure is appealing. When the debt/equity ratio is zero (there is no outstanding debt), the weighted average cost of capital is simply the cost of equity. That is, when the weight of debt in total financing is zero and the weight of equity is 1.00,

Because the cost of debt (rd) is less than the cost of equity (re), as the weight of debt increases, WACC declines. After some point, the rising weight of debt causes bond rating agencies to doubt the organization's ability to meet its debt obligations, ratings decline, and the cost of debt rises. As the cost of debt rises, with the weight of debt in the capital structure rising, the WACC must rise as well. The result is a single debt/equity ratio that minimizes the WACC and maximizes the discounted value of the organization. Even today, some textbooks in health care financial management adhere to this view, often identifying the optimal debt/equity ratio as 1.00.
The Modigliani-Miller Result
In 1958 Franco Modigliani and Merton Miller published mathematical results showing that the old view of optimal capital structure was wrong (Modigliani & Miller, 1958). The basic Modigliani-Miller (MM) result is shown in Figure 13—3.

CHAPTER 13 External Financing: Sources • 255

256 • PART 6 Long-Term Financing
As in Figure 13-2, when the debt/ equity ratio is zero (when there is no debt), the WACC is the same as the cost of equity. MM also deduced that as the weight of debt in the capital structure increases, the cost of equity (re) increases linearly (consistent with the later-developed CAPM, which states that systematic risk rises with the degree of financial leverage). At the same time that the cost of equity is rising, the
weight of equity in the WACC (We) is falling and the weight of debt (Wd) is rising. Because the cost of debt is well below the cost of equity, the effect of increasing the debt share of total financing while the cost of equity is rising causes the weighted average cost of capital to stay constant. MM's result, then, was that the weighted average cost of capital (and therefore the value of the firm) was constant at all capital structures. Thus, WACC, and the value of the firm, was based on the riskiness of the organization's expected future operating cash flows and was independent of the capital structure. Stated another way, the MM result is that the value of the organization depends on the cash flows that it expects to produce, not on how it is financed.
MM made yet another supporting argument. Suppose everyone had equal ability to borrow and lend in the capital market. Suppose further that there were an optimal capital structure. One could easily identify firms that did not have the optimal structure and purchase all of their debt and equity. That debt and equity would have less than its optimal value (at a nonoptimal capital structure, the value of the firm's securities would be less than their potential). One could then issue equity and debt in the optimal ratio and receive, from the market, the maximum value of the firm. The difference between the purchase price of the nonoptimal firm and the sale price of the securities of the now-optimal firm would be a pure profit (an arbitrage profit). Such an arbitrage opportunity cannot exist for long. Traders seeking arbitrage profits must be bidding up the prices of nonoptimally structured firms right now. The bidding for such firms will stop only at the firms' optimal values. Thus, in a world in which "homemade leverage" is possible, every observed capital structure must be an optimal capital structure.
The MM propositions were shocks to academic and practicing finance specialists. Debate on their analysis began soon after the publication of their initial article and has continued into the present (Miller, 1988; Weston, 1989). Modigliani and Miller weren't finished with their analysis, however. Following initial criticism, they revised their analysis to account for the fact that interest payments to debt holders are tax deductible for investor-owned enterprises (Modigliani & Miller, 1963). That tax deductibility further increases the difference between the cost of equity and the cost of debt. Under that tax deductibility, the WACC is a constantly declining function of the debt /equity ratio and the optimal capital structure is 100 percent debt. Miller (1977) later produced a subtle argument whose conclusion was that there was no optimal amount of debt for any one firm, but that there is an optimal amount of debt for the economy as a whole.
The idea that one can issue as much debt as one wishes without any effect on one's WACC flies in the face of what bond raters say they take into account (bond rating is covered in detail in Chapter 14). The links between debt levels and the cost of capital may lie in two effects not considered in MM's original work: bankruptcy costs and agency costs. Those links are shown in Figure 13-4.

CHAPTER 13 External Financing: Sources • 257

Bankruptcy Costs
Bankruptcy costs are losses in the value of the organization that occur during the process of declaring bankruptcy and liquidating. They include payments to attorneys and accountants and failure to obtain full value for assets sold. If there were no bankruptcy costs, lenders would have no fear of bankruptcy, as they would
receive the full par value of their loans plus accrued interest after liquidation was complete.
Agency costs are reductions in the value of the organization that occur as sup-pliers of capital recognize the ability of agents to gain at the expense of the organization (see Chapter 2). One type of agency problem (leading to agency costs) is that the greater the amount of debt in the capital structure, the greater is the incentive for the owners of equity (and their agents, management) to undertake risks.
As the percentage of debt in the capital structure grows, management may expose the organization to unwarranted risks. These risks expose the organization to an increased probability of bankruptcy, making potential bankruptcy costs more and more important. These expected bankruptcy costs eventually increase the cost of debt, causing the WACC to rise. As Figure 13–4 shows, the WACC may, then, have a unique minimum value, or a range of asset/equity ratios over which WACC takes on its minimum value. The value of the organization will be maximized when the WACC takes on the value(s) of asset/equity.
Such an optimal capital structure, if it exists, is very difficult to identify and will not be the same for every firm. McCue (1992) studied the capital structures of

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California hospitals and found that smaller hospitals tend to have higher total debt/ equity ratios than larger hospitals, but that larger hospitals have greater long-term debt than smaller hospitals.

THE CAPITAL STRUCTURE DECISION IN PRACTICE
It seems that there is no optimal capital structure that applies to all organizations everywhere at all times. The question of whether or not there is an optimal capital structure for any given firm is unresolved. In practice, health care organizations have a wide variety of capital structures, ranging from very little debt to virtually all debt financing. Table 13–1 illustrates, for a small sample of health care organizations, the range of debt/equity choices.
The first three organizations listed in Table 13-1 are investor-owned organizations. The last provider on the list, Rush-Presbyterian-St. Luke's Medical Center, is a large, not-for-profit academic medical center. All financial statement data are from their fiscal year 2000 annual reports. Stock prices for the investor-owned organizations are for the last trading days of their fiscal years (December 29, 2000 for HCA and HealthSouth, and May 31, 2000 for Tenet).
Not-for-profit organizations do not have market values for their equity, so one cannot calculate market asset/equity for them. Using the market value of equity (and assuming that the book value and the market value of debt are the same) significantly changes the investor-owned firms' asset/equity ratios. Because the market values of the firms' equity is higher than their book values, the market asset/equity ratios are lower than the book-value ratios. Note, however, that, even on a market value basis, the ratios vary substantially from firm to firm. Clearly, in practice, there is no unique "gold standard" for capital structures.
Gapenski (1993) and McCue (1992) studied capital structure decisions of hospitals. Gapenski found that a majority of both the not-for-profit and the in‑

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vestor-owned hospitals studied had target capital structures toward which they were moving. McCue found that several variables that represent financial strength (belonging to a system, for example) were positive predictors of the debt/equity ratio. That is, financial strength is related to the use of debt. Very small hospitals in McCue's study tended to use short-term borrowing a great deal, perhaps to cover cash shortfalls.
Myers (1993) described several possible explanations for organizations' strong support of one capital structure over another and for the distribution of capital structures among firms. One explanation is the pecking order theory. According to the pecking order theory, organizations prefer to finance their capital purchases with cash provided by operations. Their second choice is to incur debt, and their last choice is to dilute their ownership by issuing equity securities. The pecking order theory predicts that weak organizations will have more debt than strong organizations (as McCue found) because they generate less cash internally. The pecking order theory also predicts that growing organizations will have high debt/equity ratios, because they will outrun their internal cash capacity and will be reluctant to issue stock.
Consider again the possibility of bankruptcy costs that may drive up the cost of debt as the debt/equity ratio rises. Why do bond buyers, facing such possibilities, accept the risk inherent in very high levels of financial leverage? One explanation for investor-owned organizations is that debt requires organizations to pay out their free cash flow and, thus, is a way of reducing agency costs (Jensen, 1986). Jensen defined free cash flow as cash flow from operations above that needed to meet debt service requirements and to engage in all projects with positive net present values. Thus defined, free cash flow is cash whose best use is distribution to shareholders.
When management exercises substantial discretion as agents, they can retain free cash flow and use it to provide perquisites for themselves. In so doing, they impose agency costs on shareholders, because potential shareholders observe free cash flow's being hoarded. Investors as a group, then, would prefer that firms with substantial free cash flow substitute debt for equity. Taking on greater debt puts more debt service obligation on management. Cash that was free before in-creasing the debt/equity ratio is now owed to bond holders. Investors as a whole are better off with the higher debt /equity ratios.
Jensen further argued that one can easily identify the firms that are candidates for the debt-for-equity exchanges. These are firms that produce lots of cash but are in industries in which growth opportunities (and thus positive NPV projects) are limited. One can argue that the hospital industry fits that description nicely. Investors' desire to obligate free cash flow, according to Jensen, is one of the motivations for the leveraged buyout wave of the 1980s.
SUMMARY
Health care organizations have a wide variety of external financing options. These include common stock (investor owned only), taxable debt, and tax-exempt debt (government and not-for-profit only). The choice of mix of those financing alterna-

260 • PART 6 Long-Term Financing
tives is the capital structure decision. In practice, organizations adopt an enormous range of capital structures.
The choice of capital structure is complicated in several ways. First, the choice is important because it influences the organization's cost of capital and, therefore, overall market value. Second, there may be no clearly defined cost-minimizing capital structure. Modigliani and Miller's work, and the research that followed, showed that there may be only a vaguely defined range of optimal capital structures.
Third, the relationship between the cost of capital and the debt/equity ratio depends on the nature of the agency relationships within the organization and is not well understood. A wide range of capital structures can be consistent with organizational survival and success.