Assessing new project risk by determining new project beta values.At a capital budget meeting, three proposals are presented to a multi-disciplinary committee consisting of senior hospital administration, finance, nursing and physician leadership. [ILLUSTRATION OMITTED] The proposals include development of a new surgical service line, expansion of an existing service line and purchase of a new, high tech device. All three proposals are of strategic importance to the hospital, but the budget will allow moving forward with only two of the three. After the assumptions regarding reimbursement, expected incremental Additional or increased growth, bulk, quantity, number, or value; enlarged. Incremental cost is additional or increased cost of an item or service apart from its actual cost. cash flow, and clinical volume are discussed and validated, the proposals are evaluated based upon their net present value. A physician new to the leadership team asks how the discount rate for the proposals was determined. She is told the rate assigned is the institutional rate used for all projects. It is a management decision based on the organization's capital structure. She responds by asking whether everyone in the room believes the risk is the same for all three projects, and if not, why is the same discount rate used for all three? The group appears surprised that she should question the assumption regarding the discount rate. Is that something physician leaders should be doing? Is it valid? Physician executives and leaders increasingly are called upon to validate the underlying assumptions of financial models. Physicians play an important role in clarifying and validating assumptions related to clinical volume, referral patterns, evidence-based practice, and length of stay. Nowhere is this more evident than in a hospital's capital budgeting process. With hospitals depending on a few profitable service lines to carry the overall operating margin Operating Margin A ratio used to measure a company's pricing strategy and operating efficiency. Calculated by: of the institution, and with more capital budget choices than dollars available, these capital budget decisions leave little room for error. As a result, physician business and leadership training has focused on gaining an understanding of the elements of net present value analysis, as part of the capital budgeting process. However, when evaluating differing proposals, rarely do hospitals or physicians question the assumptions underlying the estimate of risk. Often, institutional discount rates are established and applied to the analysis of all projects. Is this assumption any less critical to the analysis? No, yet rarely are physicians asked to evaluate the validity of the discount rate used, as it applies to the overall risk of a project. Institutional discount rates are determined by calculating an organization's weighted average cost of capital Weighted average cost of capital (WACC) Expected return on a portfolio of all a firm's securities. Used as a hurdle rate for capital investment. Often the weighted average of the cost of equity and the cost of debt The weights are determined by the relative proportions of equity (WACC WACC See: Weighted average cost of capital ). It is determined by adding the weighted cost of debt to the weighted cost of equity to determine the required rate of return. For example, assume that the cost of debt is 5 percent and that debt makes up 20 percent of your capital structure, while the cost of equity is 15 percent and equity constitutes 80 percent of your capital structure. The weighted average cost of capital (WACC) is then: WACC= (5%)(20%) + (15%)(80%) = 1% + 12% = 13% Therefore, your required rate of return (discount rate, hurdle rate Hurdle Rate The minimum amount of return that a person requires before they will make an investment in something. Notes: This is the rate of return that will get someone "over the hurdle" and invest their money. ) is 13 percent. The next question is how do we determine the elements of the WACC? The percent of debt and equity in the capital structure is obtained from the organization's balance sheet. The calculation for the cost of debt is a simple one. It is determined by how much an organization pays in interest on its debt multiplied by one minus the tax rate. For example, if your debt rate is 5 percent, and your corporate tax rate is 22 percent, then your cost of debt is: Cost of Debt = 5% x (1 - 22%) = 4% For not-for-profit corporations A not-for-profit corporation is a corporation created by statute, government or judicial authority that is not intended to provide a profit to the owners or members. A corporation that is organized to provide profits to its owners or members is a for-profit corporation. , which do not pay income tax, it is equal to the debt rate. The cost of equity is more difficult to determine. The most commonly accepted method in finance is the capital asset pricing model Capital asset pricing model (CAPM) An economic theory that describes the relationship between risk and expected return, and serves as a model for the pricing of risky securities. (CAPM CAPM See: Capital asset pricing model CAPM See capital-asset pricing model (CAPM). ). Figure 1 shows the formula for the CAPM. There are three major elements to the CAPM. The first is the risk free rate. This is the rate of return you can expect on risk-free investments. The standard risk-free investment by which this is measured is the 90-day U.S. Treasury U.S. Treasury Created in 1798, the United States Department of the Treasury is the government (Cabinet) department responsible for issuing all Treasury bonds, notes and bills. Some of the government branches operating under the U.S. Treasury umbrella include the IRS, U.S. Bill. The current rate of return on T-Bills may be obtained from publications such as The Wall Street Journal. The second element of the CAPM is the expected rate of return expected rate of return The rate of return expected on an asset or a portfolio. The expected rate of return on a single asset is equal to the sum of each possible rate of return multiplied by the respective probability of earning on each return. on a market investment. The 45-year historical average has been in the range of 10-12 percent. The final component is beta, which represents the measure of a company's risk relative to the overall market. For publicly traded companies publicly traded company A company whose shares of common stock are held by the public and are available for purchase by investors. The shares of publicly traded firms are bought and sold on the organized exchanges or in the over-the-counter market. , an estimate of the beta may be obtained from publications such as Value Line. Taking a company's returns and plotting them against the returns of the S & P 500 determines beta. Linear regression Linear regression A statistical technique for fitting a straight line to a set of data points. analysis is then used to determine the slope of the "best fit" line through the plotted points. Beta is the slope of the "best fit" line. Therefore, beta is measured relative to a risk level of one. Those companies with the same risk as the overall market will have a beta of one. Likewise, those with a beta of greater than one would have more risk, and those with less than one, less risk. The beta used to determine risk, and from that, cost of equity, WACC, and the discount rate for an institution is a reflection of the risk of the entire organization's cash flow. It does not reflect the risk associated with the incremental cash flows Incremental cash flows Difference between the firm's cash flows with and without a project. associated with a new project, new building, or new piece of equipment. Rates for new projects How then do we determine the beta and ultimately the risk and discount rate to be used for new projects? [ILLUSTRATION OMITTED] Antonio Bernardo, Bhagwan Chowdry, and Amit Goyal, from the Anderson School Anderson School may refer to:
For the health care industry, they calculated the need to adjust betas by 0.259 to 0.338 for new projects, beyond the institution's beta for assets in place. The increase in beta used depends on the perceived risk of the cash flows of the new project. To illustrate this point, assume an organization's beta for its assets in place is 1.0. Then the beta for its new projects should range from 1.259 to 1.338, reflecting high and low risk projected cash flows for new projects. How would this impact the overall discount rate? If we assume the organization has no debt, then its discount rate will be determined by the cost of equity. If we assume a beta of 1 for its assets in place, a risk free rate of 2 percent, and an expected rate of return of 12 percent, then the cost of equity equals: Cost of equity = 2% + 1.0(12% + 2%) = 16% Then for new projects, using the adjusted increase in beta, the cost of equity will be: Cost of Equity low risk = 2% + 1.259(12% + 2%) = 18% Cost of Equity high risk = 2% + 1.338(12% + 2%) = 21% Based on these calculations, the NPV NPV See: Net present value would then be determined using a discount rate between 18 percent and 21 percent depending on the risk of the cash flows. If we applied this rationale to our original example, the risk of the cash flows for a new service line would be much higher (21 percent) than those for a growth project within an existing service line (18 percent). The cash flows from revenue generated by the new piece of equipment might fall somewhere between these two (19.5 percent). The overall result would be NPVs for each project appropriately adjusted for the risk of the cash flows associated with each, allowing a more accurate "apples to apples" comparison between the three projects. Physician leaders increasingly are being called upon to validate the assumptions underlying financial models used in capital budgeting decisions. By questioning not only the reimbursement, expected incremental cash flow and clinical volume assumptions, but also the risk, and thus the discount rates used in NPV analysis, physician leaders may provide greater accuracy to financial analyses and allow hospitals to make better, more rational choices in an era of limited capital resources. David P. Tarantino, MD, MBA MBA abbr. Master of Business Administration Noun 1. MBA - a master's degree in business Master in Business, Master in Business Administration , is executive medical director of Shock Trauma Associates, P.A., a 50+ physician, multispecialty practice associated with the University of Maryland University of Maryland can refer to:
LLC - Logical Link Control , a health care management consulting Noun 1. management consulting - a service industry that provides advice to those in charge of running a business service industry - an industry that provides services rather than tangible objects firm in Baltimore. He can he reached by phone at 410-328-2036 or by e-mail at mdcg@verizon.net Reference 1. Bernardo AE, Chowdry B, and Goyal A. "Growth Options, Beta, and the Cost of Capital." Journal of Finance: 2005. By David Tarantino, MD, MBA Figure 1 Determining the Cost Equity using The Capital Asset Pricing Model (CAPM) Cost of Equity = risk free rate + beta(market risk premium + risk free rate) |
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