HM 416 Chapter 7

1. © 2018 American Health Information Management Association© 2018 American Health Information Management Association
Principles of Finance for
Health Information and
Informatics Professionals
Second Edition
Chapter 7
Cost of Capital

2. © 2018 American Health Information Management Association
Learning Objectives
• Describe how organizations determine the need for
external financing
• Explain factors that influence interest rates
• Calculate the present or future value of a lump sum
investment
• Specify the types of external financing available to
healthcare organizations
• List and describe the types of investments
available to healthcare organizations

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Need for Financing
• Individuals borrow money for major purchases
– Home
– Car
• FICO (Fair Isaac Corporation) score determines the terms
of the loan
• Better credit score = less risk of default = lower interest rate
• Organizations also borrow money for major purchases
– Construction of new facilities
– New equipment
• Ability to borrow money and terms of loan also determined
by credit or bond rating
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Budget Review
• Cash Budget
– Planning for collections of receivables
– Expending cash to resolve payables
– Derived from the net cash in/out flows from the operating and capital
budget
• Operating Budget
– Generating revenue via primary business purpose of organization
– Costs associated with generating the revenue
• Capital Budget
– Acquisition of fixed assets
– Cost of capital
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Capital Budget – Key Components
• Estimates expenditures to acquire or replace
long-term assets
• Capital Assets (fixed assets)
– Property, plant, and equipment (PPE)
• Property = land, parking lots, helipad, etc.
• Plant = Buildings and structures
• Equipment = Automobiles, owned MRI machine, some furniture
– Physical assets with useful life > 1 year
– Value that exceeds a threshold set by organization
– Value will be depreciated for financial reporting
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Time Value of Money
• Projects and investments evaluated in terms of
contribution to organization
– Increased market share
– Increased asset value
– Positive return on investment (ROI)
• ROI
– Cash inflows due to investment
– Increased value of investment
• Investments are expected to grow over time
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Interest-Bearing Instruments
• ROI = interest paid to investor
• Interest is calculated based on the value of
the account
• ROI depends on:
– Amount invested
– Interest rate
– Period (how often interest is paid)
– Simple vs. compound interest payments
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Compound vs. Simple Interest
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Change in period
impacts timing of
interest payout, but not
amount
Compounding impact
amount of interest paid
since interest is paid on
(principle + interest to
date)

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Discounted Instruments
• Investment pays a set amount at end of period
– Treasury bills
• Investment amount is calculated by reducing the
ending value by a discount rate
• Discount rate ≠ rate of return
• Example:
– $10,000 instrument
– Discount rate = 5%
– Buy for $10,000 – 0.05 × $10,000 = $9,500
– Rate of return is:
(10,000-9,500)/9,500 = 500/9,500 = 5.26%
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Interest and Value Vocabulary
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Present Value vs Future Value
• Investments are expected to grow over time
• Inflation impacts the value of investment as well as the
return
• From simple interest example: $100,000 invested at
5% has a future value of $105,000 after one year
• In order to ensure the value after one year is $105,000,
the amount to be invested is the present value or
$100,000
• These are converse concepts
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Future Value
• FV = future value
• PV = present value
• r = rate
• n = number of periods interest is paid
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 n
rPVFV  1

13. © 2018 American Health Information Management Association
Future Value—Example 1
• How much is an investment of $100,000 at 6%
simple interest paid annually worth after one year?
• FV = ?
• PV = $100,000
• r = 6% ; period = year
• n = 1 year
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  000,10606.01000,100
1
FV
 n
rPVFV  1

14. © 2018 American Health Information Management Association
Future Value—Example 2
• How much is an investment of $100,000 at 6%
compound interest paid annually worth after five
years?
• FV = ?
• PV = $100,000
• r = 6%; period = year
• n = 5 year
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  822,13306.01000,100
5
FV
 n
rPVFV  1

15. © 2018 American Health Information Management Association
Present Value
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 n
rPVFV  1
  n
n
r
FV
rFVPV
)1(
1




16. © 2018 American Health Information Management Association
Present Value Example
• FV = $133,822 (from previous example)
• R = 6%
• N = 5 periods (years)
• PV = ?
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000,100
33822.1
822,133
)06.01(
822,133
)1( 5




 n
r
FV
PV
  n
n
r
FV
rFVPV
)1(
1




17. © 2018 American Health Information Management Association
Adjusting for Multiple Payments per
Year
• Units of measurement for “periods” much match
• Example: What is the future value of an investment of
$100,000 at 6% interest paid semi-annually for 5
years?
– Period is now 6 months (semi annual)
– PV = $100,000
– r = 0.06/2 = 0.03 per period
– n = 2×5 = 10 periods
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  392,13403.01000,100
10
FV
 n
rPVFV  1

18. © 2018 American Health Information Management Association
Net Present Value—Excel
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Loan Payments—Excel
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Inflation and Interest Rates
• If economy is growing, price of goods and services
increases—inflation
• Consumer price index (CPI) is one measure of inflation
– Calculated by BLS
– Components include particular market basket of goods (e.g.
medical CPI)
• Banks loan money to each other using a discount rate
• Federal funds rate: rate at which banks lend reserves
to each other
• Prime rate: rate banks load money best customers
(low risk of default)
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Credit Ratings
• Opinion of “experts” of the ability of an organization to
pay back a debt
• Low credit rating = high risk = high rate on financing
• High credit rating = low risk = lower rate on financing
• Major credit rating agencies
– Morningstar: AAA to D
– Moody’s: Aaa to C
– Standard & Poor’s (S&P): AAA to D
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Sources of Capital Funding
• Short-term liabilities
• Long-term liabilities
• Equity
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Short-Term Debt
• Repaid within one year
• Appear in Current Liabilities on Balance Sheet
• Credit line
– Used to fill “gaps” in cash flow
– May cover payroll while waiting for AR to resolve
• Secured
– Guaranteed against an asset: collateral
– Personal finance example: home equity line of credit
– Preferential treatment in the case of bankruptcy
• Unsecured
– No collateral
– Personal finance example: credit card
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Short-Term Debt Example
• 90-day commercial paper is issued by the organization at a
discount from par value of $1M for a discount rate of 4%.
• Translation: An organization needs to borrow cash to cover
payroll for 90 days. The lender will make a loan with a FV of
$1M at a discount rate of 4%.
• n = 90 days (one quarter)
• r = 4% annually or 0.04/4 = 0.01 per quarter
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099,990
01.1
000,000,1
)01.01(
000,000,1
)1( 1




 n
r
FV
PV

25. © 2018 American Health Information Management Association
Short-Term Debt Example
• 90-day commercial paper is issued by the organization
at a discount from par value of $1M for a discount rate
of 4%
• Translation: An organization needs to borrow cash to
cover payroll for 90 days. The lender will make a loan
with a FV of $1M at a discount rate of 4%.
• Organization will receive $990,099 and must pay back
$1,000,000
• Financial statement impact—balance sheet:
– Cash increases $990,099
– Current liabilities increases $1,000,000
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26. © 2018 American Health Information Management Association
Short-Term Debt
• Interest calculation depends on the type of
instrument used to borrow
• Commercial paper: sold at a discount as in
previous example
• Credit line: interest charged on the average
balance during a period (like credit cards)
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Long-Term Debt
• Appears on the balance sheet under long term
liabilities
• Due date longer than 12 months away
• Not for profit entities may issue bonds
– Investment banker determines appropriate term and
interest rate
– Securities Exchange Commission (SEC) must
approve bond issuance to public
• For profit entities may sell stock (IPO)
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Bonds
• Like stock, the purchase rate depends on the market
• Market rate may be more/less than face value
• Bonds used to be issued with “coupons”
– Investors submitted the coupons to receive payment from the bond
issuer
– Periodic rate paid by the bond issuer still called the coupon rate
– Bonds without an interest rate are called zero coupon bonds
• Bonds raise cash for not for profit organizations
– Essential a “loan” made by the purchaser of the bond
• NFP organizations cannot sell stock – cannot be “owned”
by individuals
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Equity
• Retained earnings, also called fund balance
– An accumulation of (revenue - expenses) from income statement
over time
– Sufficient fund balance lowers the dependence of an organization
on external funding or financing of capital projects
• Charitable donations
– Unrestricted: increases general fund balance
– Restricted: may only be used for a particular purpose or project
• Partnership: owner’s equity
– For profit
• Common Stock
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Other Capital Financing Strategies
• Refinancing
– More favorable interest rate or change in term
(length)
• Sale of Accounts Receivable
– Uncollectable or bad debt may be sold to third
party for collection
– Sold at a discount because of the risk and effort
required to collect the receivable
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Refinancing Example

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Cash Management and Investment
Strategies
• Healthcare organizations must invest fund balance
according to investment policy
• Factors that influence investment policy:
– Need to access principle
– Risk tolerance
– Mission
• Investment vehicles (from least to most risk/return)
– Interest bearing accounts
– Certificates of deposit (CD)
– Money Market
– Managed portfolios
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33. © 2018 American Health Information Management Association
Summary
• Organizations often need to obtain funding from
external sources to meet their cash needs for routine
operations and to finance capital investments
• An organization’s ability to obtain financing is
affected by its credit rating and tax status
• Not-for-profit organizations cannot issue stock but
may obtain debt financing and may accept tax-
deductible donations
• For-profit organizations may obtain equity or debt
financing, but donations are not tax-deductible to the
donor