Download Concept 6 Kaufman

Best Practice Financial Managment
By Kenneth Kaufman
Concept Six
Achieving the Right Capital Structure
David Herren
July 19, 2007
Outline
With the fluid nature of the financial marketplace comes the need to have financial leaders that pay attention to
interest costs on a regular basis and manipulate the capital structure when opportunities emerge to lower overall
capital costs and increase flexibility.
Overview of Capital Structure and the Benefits of Its Effective Management
 Capital structure is the combination of debt and equity that funds and organization’s strategic plan.
 All healthcare organizations must raise capital to buy the assets required to meet their strategic
objectives.
 Strategies used in the for-profit world can set not-for-profit organizations apart from their competitors.
Debt/Equity Financing and Traditional/Nontraditional Financing
 Capital from external sources is classified as either debt capital or equity capital.
 Debt capital is available in three major categories:
o 1. Traditional Public Offerings – can be taxable or tax exempt and can have fixed or variable
rates. Can be sold to any party interested in owning bonds.
o 2. Traditional Private Offerings – debt offered by a limited universe of lenders (banks, leasing
companies, insurance companies, etc.) Can be taxable or tax exempt and can carry fixed or
variable interest rates.
o 3. Nontraditional Vehicles – Numerous (receivables financing, off-balance-sheet options, real
estate investments, etc.) Most are taxable. These are usually accessed due to a lack of
alternatives.
Evaluation Criteria
 Because financial status determines an organization’s accessible vehicles, several criteria are used to
evaluate its circumstances and credit position.
o 1. All-in borrowing rate – this is the total cost of capital including interest costs and ongoing fees
involved with maintaining the financing.
o 2. Costs of issuance – Tax exempt bonds typically have higher costs of issuance.
o 3. When the money is needed – The timing of when the hospital needs to spend the money may
affect its choice of vehicle.
o 4. Use of proceeds – The tax status of the financing option depends on the tax status of the
entity for which the financing is being sought.
o 5. Credit position – The credit available to an organization largely determines which vehicles it
can access.
o 6. Document structure and underlying security requirements – The weaker the credit, the more
security is required.
o 7. Covenants – There are two basic categories: maintenance and incurrence.
o 8. Principal amortization – The amortization schedule for the financing vehicle is critical to cash
flow and maintenance covenants.
o 9. Interest rate risk – the best course is to achieve a mix of fixed and variable-rate debt that
minimizes interest rate risk.
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Concept Six
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10. Average useful life versus average maturity – Projects eligible for tax exemption be
specifically delineated in the documents that support the borrowing.
11. Disclosure requirements – Tax-exempt vehicles require organizations to provide disclosure of
certain financial and utilization information.
12. Prepayment penalties and unwind provisions – different vehicles have different premiums
and prepayments associated with an early redemption date.
Fixed-Rate Debt and Variable-Rate Debt
 Variable-rate interest costs have been lower since 1991 and often significantly lower than
fixed-rate costs.
 Diversification of variable rate products is essential to maximizing capital.
 Careful examination and monitoring of an organization’s variable-rate program should allow the
organization to achieve the lowest cost of capital possible.
Swaps and Other Derivatives
 A derivative is any sort of contract that manages or adjusts the character of underlying securities whether
debt or equity.
 They allow hospitals to maintain a flexible capital structure.
 Allows a hospital to make changes to its capital structure in real time with changes in the stock market.
 Examples of derivates are plain-vanilla caps, chooser caps, collars, corridors, and knockout caps
 Heavily used by hospitals.
 An interest rate swap is a contract between two parties to exchange interest rate modes on a specific
amount and type of debt.
o Three types: fixed payer swaps, fixed receiver swaps, and basis swaps.
 Fixed payer swaps – convert variable-rate debt to fixed-rate debt.
 Fixed receiver swaps – convert a hospital borrower’s fixed-rate debt into variable-rate
debt.
 Basis swaps – result from combining and tax-exempt fixed-to-floating swap with a LIBOR
floating-to-fixed swap.
Portfolio Monitoring and Adjustment
 Capital market and competitive environment changes make it critical for healthcare organization to
continuously monitor capital structure and every other aspect of the capital management cycle.
 High-quality capital structure management is increasing the gap between those hospitals to access to
low-cost capital and those without such access.
Terms & Definitions
Capital Structure – The combination of debt and equity that funds and organization’s strategic plan.
Derivative – any sort of contract that manages or adjusts the character of underlying securities whether debt or
equity.
Interest Rate Swap – a contract between two parties to exchange interest rate modes on a specific amount and
type of debt.
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Concept Six