The economics of for-profit and not-for-profit hospitals

Health Affairs

Volumn 19, Issue 6, 2000, Pages 178-186

  Reinhardt, Uwe E ^a  

^a PRINCETON UNIVERSITY   (United States)

Author keywords

[No Author keywords available]

Indexed keywords

ARTICLE; COMPARATIVE STUDY; ECONOMICS; FINANCIAL MANAGEMENT; HEALTH CARE COST; HEALTH CARE POLICY; HOSPITAL; HOSPITAL COST; HUMAN; INCOME; NON PROFIT HOSPITAL; STATISTICS; TAX; UNITED STATES;

CAPITAL EXPENDITURES; FINANCIAL MANAGEMENT, HOSPITAL; HEALTH POLICY; HOSPITAL COSTS; HOSPITALS, PROPRIETARY; HOSPITALS, VOLUNTARY; HUMANS; INCOME; TAX EXEMPTION; UNITED STATES;

EID: 0034332338     PISSN: 02782715     EISSN: None     Source Type: Journal    
DOI: 10.1377/hlthaff.19.6.178     Document Type: Article

References (15)

1. G. Claxton et al., "Public Policy Issues in Nonprofit Conversions: An Overview," Health Affairs (Mar/Apr 1997): 13.
2. B. Gray, "Conversion of HMOs and Hospitals: What's at Stake?" Health Affairs (Mar/Apr 1997): 32.
3. See U.E. Reinhardt, "The Rise and Fall of the Physician Practice Management Industry," Health Affairs (Jan/Feb 2000): 42-55.
4. Although depreciation expense is deducted from revenues in calculating accounting income, depreciation is a noncash expense calculated by accountants to allocate the cost of long-lived assets to several accounting periods. Depreciation expense enters a capital-budgeting analysis only insofar as it shields income from taxation, thereby preventing an outflow of cash to the government.
5. In this exercise we use the Modified Accelerated Cost Recovery System (MACRS) depreciation rates currently in use.
6. To illustrate, if the incremental cash operating income due one year after the acquisition were $1 million and the weighted average cost of capital (WACC) were 10 percent, then the presentvalue equivalent of that cash flow would be $1,000,000/1.10 = $909,090. If the corresponding cash flow three years hence were $1 million as well, its present-value equivalent would be $1,000,000/1.103 = $751,315.
7. Because of flotation costs, the cost of equity procured via newly issued stock certificates is actually slightly higher than the cost of equity capital procured simply by retaining earnings. We ignore that fine point here.
8. Issuing and selling new stock certificates involves flotation costs that are avoided when equity financing is procured through retained earnings. Therefore, in theory, the cost of retained earnings is somewhat lower than that of equity procured via a new stock issue. For the sake of simplicity, we ignore this fine point, as do many practitioners in the field.
9. The uncertainty surrounding the returns to shareholders can be broken down into two components: variability that is systematically related to general market conditions (the stock's "systematic" risk), and variability unique to the firm in question (the stock's "unsystematic" risk). It can be demonstrated with modern portfolio theory that a well-diversified portfolio of fifty stocks or more will eliminate from the investor's perspective virtually the entire "unsystematic" risk inherent in common stocks. Thus, the risk for which an efficient stock market rewards the investor is only the "systematic," market-related risk that cannot be eliminated through portfolio diversification. In practice, the magnitude of a stock's "systematic risk" is measured empirically (and highly imperfectly) by the so-called beta coefficient of the stock.
10. The formal theory underlying this construct is the Capital Asset Pricing Model. See, for example, R.A. Brealey and S.C. Myers, Principles of Corporate Finance (New York: McGraw Hill, 2000), chap. 8.
11. See L.C. Gapenski, Understanding Health Care Financial Management (Ann Arbor, Mich.: AUPHA Press/Health Administration Press, 1993), chap. 8. By this reasoning, funds donated for and therefore restricted to a particular philanthropic purpose would have a zero cost of capital, because they do not have an opportunity cost.
12. The details of this analysis are available from the author at .
13. Political constraints and public relations may nevertheless make it profitable for the for-profit hospital to be seen rendering some unrequited community benefits.
14. Although about half of American households now directly or indirectly own common stock, it is well known that the bulk of common stock in this country is owned by only a small minority of wealthy households. In this connection, see E.N. Wolff, "Why Stocks Won't Save the Middle Class" (Unpublished paper, New York University, 25 March 1999).
15. See U.E. Reinhardt, "Abstracting from Distributional Effects, This Policy Is Efficient," in Health Care and Health Economics, ed. M.L Barer, T.E. Getzen, and G.L Stoddard (New York: Wiley, 1998), 1-52.