ANSWERS TO END-OF-CHAPTER QUESTIONS
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1 This is a sample of the instructor resources for Louis C. Gapenski, PhD, Fundamentals of Healthcare Finance, Second Edition. The complete instructor resources include Test Bank PowerPoint slides Sample course syllabus Solutions to the end-of chapter questions and problems Solutions to the online cases This sample includes the following resources for Chapter 2: Answers to end-of-chapter discussion questions PowerPoint slides If you adopt this text, you will be given access to the complete materials. To obtain access, e- mail your request to hapbooks@ache.org and include the following information in your message: Book title Your name and institution name Title of the course for which the book was adopted and season course is taught Course level (graduate, undergraduate, or continuing education) and expected enrollment The use of the text (primary, supplemental, or recommended reading) A contact name and phone number/ address we can use to verify your employment as an instructor You will receive an containing access information after we have verified your instructor status. Thank you for your interest in this text and the accompanying instructor resources.
2 Healthcare Business Basics Chapter 2 ANSWERS TO END-OF-CHAPTER QUESTIONS 8/1/ a. A business is an entity that obtains financing from the marketplace, uses those funds to buy assets (e.g., land, buildings, equipment, and inventories), and finally uses those assets to create goods or services that are sold to the public. b. A pure charity obtains contributions and then distributes those funds to meet the charitable goals of the organization. A (not-for-profit) business s primary source of funds is revenues from the sale of goods and services rather than contributions, so its structure and financial management are inherently different from those of a pure charity. 2.2 The three primary forms of business organization are the (1) proprietorship/partnership, (2) corporation, and (3) hybrid. A proprietorship, sometimes called a sole proprietorship, is a business owned by one individual. A proprietorship is easily and inexpensively formed, is subject to few governmental regulations, and pays no corporate income taxes. A partnership is formed when two or more persons associate to conduct a nonincorporated business. Like a proprietorship, the major advantages of the partnership form of organization are its low cost and ease of formation. In addition, the tax treatment of a partnership is similar to that of a proprietorship; the partnership's earnings are allocated to the partners and taxed as personal income, regardless of whether the earnings are actually paid out to the partners or retained in the business. Proprietorships and partnerships have three important limitations: 1. It is difficult for owners to sell their interest in the business. 2. Owners have unlimited personal liability for the debts of the business, which can result in losses greater than the amount invested in the business. In a proprietorship, unlimited liability means that the owner is personally responsible for the debts of the business. In a partnership, it means that if any partner is unable to meet his or her pro rata obligation in the event of bankruptcy, the remaining partners are responsible for the unsatisfied claims and must draw on their personal assets if necessary. 3. The life of the business is limited to the life of the owners. These three disadvantages difficulty transferring ownership, unlimited liability, and impermanence of the business lead to the fourth and perhaps the most important disadvantage from a finance perspective: the difficulty that proprietorships and partnerships have attracting substantial amounts of capital. A corporation is a legal entity that is separate and distinct from its owners and managers. The creation of a separate business entity gives the corporation three main advantages: 1. A corporation has unlimited life and can continue in existence after its original owners and managers have died or left the company. 2. It is easy to transfer ownership in a corporation because ownership is divided into shares of stock that can be easily sold. 3. Owners of a corporation have limited liability. The corporate form of organization has two primary disadvantages. First, corporate earnings of taxable entities are subject to double taxation: once at the corporate level and Copyright 2012 Health Administration Press 2-1
3 Chapter 2 Healthcare Business Basics again at the personal level when dividends are paid to stockholders. Second, the tasks of setting up a corporation and filing the required periodic state and federal reports are more costly and time consuming than those required to establish a proprietorship or partnership. Hybrid forms of business are designed to combine the best features of proprietorships/partnerships and corporations. Examples include limited liability partnerships (LLPs), limited liability companies (LLCs), and professional corporations (PCs) (called professional associations [PAs] in some states). In general, these forms of organization provide a way for professionals to either partner or incorporate yet still be held personally liable for professional malpractice. 2.3 There are three key features of investor-owned corporations. First, the owners (the stockholders) of the business are well defined and exercise control of the firm by voting for its directors. Second, the residual earnings of the business belong to the owners, so management is responsible only to the stockholders for the profitability of the firm. Finally, investor-owned corporations are subject to taxation at the local, state, and federal levels. If an organization meets a set of stringent requirements, it can qualify for incorporation as a tax-exempt corporation. Tax-exempt corporations are sometimes called nonprofit or not-for-profit corporations. Because nonprofit businesses (as opposed to pure charities) need profits to sustain operations, and because it is hard to explain why nonprofit corporations should earn profits, the term not for profit makes more sense, especially in a finance context. Not-for-profit corporations differ significantly from investor-owned corporations. Because not-for-profit firms have no shareholders, no single body of individuals has ownership rights to the firm's residual earnings or exercises control of the firm. Rather, control is exercised by a board of trustees that is not constrained by outside oversight. Also, not-for-profit corporations are generally exempt from taxation, including property and income taxes, and they have the right to issue tax-exempt debt (municipal bonds). Finally, individual contributions to not-for-profit organizations can be deducted from taxable income by the donor, so not-for-profit firms have access to tax-subsidized contribution capital. 2.4 As opposed to a standard corporation (C corporation), a benefit corporation (B corporation) allows corporate boards and managers to sacrifice shareholder value for the greater good. Benefit corporations must specify their social and environmental goals in the company s bylaws. Furthermore, such corporations must publish an annual benefit report that measures how well these goals are being met. 2.5 a. The primary goal of investor-owned corporations is shareholder wealth maximization. b. The primary goal of most not-for-profit healthcare organizations generally takes the form of a mission, such as to enhance the health of the communities they serve. c. Despite overall goal differences, there is little difference between the finance goals of investor-owned and not-for-profit businesses. In general, the finance function must ensure the financial viability of the organization and support organizational goals. d. An agency problem exists when one or more individuals (the principals) hire another individual or group of individuals (the agents) to perform a service on their behalf and then delegate decision-making authority to those agents. In the healthcare finance framework, the agency problem exists between stockholders and managers and between debtholders and stockholders. Copyright 2012 Health Administration Press 2-2
4 Healthcare Business Basics Chapter 2 The agency problem between stockholders and managers occurs because the managers of large, investor-owned firms hold only a small proportion of the firm's stock, so they benefit little from stock price increases. On the other hand, managers benefit substantially from such actions as increasing the size of the firm to justify higher salaries and more fringe benefits, awarding themselves generous retirement plans, and spending too much on office space, personal staff, and travel actions often detrimental to shareholders' wealth. Clearly, many situations can arise in which managers are motivated to take actions that are in their best interests rather than in the best interests of the firm's stockholders. A similar agency problem exists between the managers and other stakeholders primarily the communities served in not-for-profit organizations. Shareholders (or other stakeholders in not-for-profit organizations) recognize the agency problem and counter it by creating compensation incentives, such as stock options and performance-based bonus plans, that encourage managers to act in shareholders' interests. Additionally, other factors, such as the threat of takeover or removal, are at work to keep managers focused on shareholder wealth maximization. 2.6 a. Tax laws are important to healthcare finance because the value of any investment whether the investment is a stock, a bond, or an entire business depends on the usable cash flows (i.e., the cash flows after all taxes and fees have been paid) that the investment is expected to provide to the owner. Thus, healthcare finance analyses must include tax implications, at least for businesses that must pay taxes. b. The three most important tax benefits to not-for-profit corporations include the following: 1. By not paying taxes, the usable earnings of a not-for-profit corporation are greater than those of a similar for-profit entity. 2. Not-for-profit corporations can issue municipal bonds and hence pay lower interest rates on their debt financing. 3. Not-for-profit businesses have access to contribution capital because contributions to such organizations are tax deductible to the donor. ANSWERS TO END-OF-CHAPTER PROBLEMS 2.1 a. With $1 million of taxable income and a 30 percent tax rate, the hospital s taxes are 0.30 $1,000,000 = $300,000, and its net income is $1,000,000 $300,000 = $700,000. Alternatively, after-tax income can be calculated as follows: AT = BT (1 T) = $1,000,000 (1 0.30) = $1,000, = $700,000. b. AT = BT (1 T) = $10,000 (1 0.15) = $10, = $8,500. Copyright 2012 Health Administration Press 2-3
5 Chapter 2 Healthcare Business Basics 2.2 If only 30 percent of the $100,000 dividend is taxable, taxes need be paid only on 0.30 $100,000 = $30,000. At a rate of 35 percent, the firm s taxes are 0.35 $30,000 = $10,500. Therefore, the after-tax dividend is $100,000 $10,500 = $89,500. Note that because of the dividend exclusion, the effective tax rate was reduced from the 35 percent normal rate to $10,500 $100,000 = = 10.5 percent. Alternatively, AT = BT (1 Effective T) = $100,000 (1 [0.30][0.35]) = $100,000 ( ) = $100, = $89, a. b. HCA: AT = BT (1 T) = 12% (1 0.40) = 12% 0.60 = 7.2%. Twin Cities: AT = BT (1 T) = 6% (1 0) = 6% 1.0 = 6%. Kim should buy the HCA bonds because they have a higher return after taxes are considered. c. Because the Twin Cities bonds must yield 7.2 percent after taxes to be indifferent and because they are tax exempt; the interest rate on the bonds must be 7.2 percent. 2.4 Because the interest rate on taxable bonds is treated as ordinary income, the taxable bonds must yield 7 percent after taxes are paid, so AT = BT (1 T) 7% = BT (1 0.40) = BT 0.60 BT = 7% 0.60 = 11.67%. 2.5 Without the contribution, the tax bill would be: 0.48 $2,000,000 = $960,000 With the contribution, it would be: 0.48 $1,500,000 = $720,000 Impact of the contribution on taxes: $240,000 Note that the reduction in taxes that results from a tax deduction is called a tax shield. It is calculated as T Amount of deduction. In this example, the tax shield is 0.48 $500,000 = $240,000. Copyright 2012 Health Administration Press 2-4
6 2-1 CHAPTER 2 Healthcare Business Basics Concept of a business Legal forms of business FP versus NFP ownership Organizational goals Financial goals Taxes
7 2-2 Concept of a Business A business is an entity that: Raises money in the capital markets. Invests these funds in assets (land, buildings, equipment, inventories, and so on). Uses these assets to create products or services. Sells these products or services to sustain itself. A pure charity is different. Why?
8 2-3 Legal Forms of Business There are four major categories of business organization (legal forms of businesses). Proprietorship (sole proprietorship) Partnership Corporation Hybrid forms How much does the organizational form influence the practice of healthcare finance?
9 Proprietorships and Partnerships Advantages Ease of formation Subject to few regulations No corporate income taxes Disadvantages Limited life Difficult to transfer ownership Unlimited liability Difficult to raise capital 2-4
10 2-5 Corporation Advantages Unlimited life Easy transfer of ownership Limited liability Ease of raising capital Disadvantages Cost of formation and reporting Double (or triple) taxation for investorowned corporations
11 2-6 Hybrid Forms of Organization Limited partnership (LP) General partners have control Limited partners are liable only for their initial contribution Not commonly used by healthcare providers Limited liability partnership (LLP) Partners share general business liability But, partners are liable only for their own malpractice actions
12 Limited liability company (LLC) Members are taxed like partners Liability like stockholders 2-7 Hybrid Forms of Organization (Cont.) Professional corporation (PC) or professional association (PA) Owners have benefits of incorporation However, still liable for malpractice Often used by individual clinicians
13 2-8 Alternative Forms of Ownership In most industries, the only form of ownership is the investor-owned (forprofit) business. However, in the health services industry, a significant proportion of businesses, particularly hospitals, are organized as not-for-profit corporations. How much does ownership influence the practice of healthcare finance?
14 2-9 Investor-Owned (For-Profit) Corporations Investors become owners by purchasing shares of common stock. Primary market transactions Initial public offerings (IPOs) New common stock sales Secondary market transactions On exchanges In the over-the-counter market Stockholders have: Right of control Claim on residual earnings and residual liquidation proceeds
15 2-10 Not-For-Profit Corporations If a business meets certain requirements, it can qualify as a not-forprofit (nonprofit) corporation. These corporations: Generally have no shareholders, and hence do not have a single clientele to which managers are responsible. Receive various tax exemptions. Can be roughly thought of as being owned by the community.
16 Not-For-Profit Corporations (Cont.) 2-11 NFP corporations are required to file Form 990 (Return of Organization Exempt from Income Tax) with the IRS. This form, which is available to the public, provides information on corporate governance and executive compensation. In addition, NFP hospitals are required to attach Schedule H, which provides information about charity care, other community benefit activities, and collection practices.
17 2-12 Organizational Goals The primary goal of for-profit corporations is shareholder wealth (stock price) maximization. The primary goal of not-for-profit corporations is generally given by a mission statement, often in terms of service to the community. What is the primary goal of proprietorships and partnerships?
18 2-13 Stakeholders All businesses have stakeholders, who are parties that have an interest (often financial) in the business Stakeholders include owners (if FP), managers, employees, suppliers, patients, and even the community at large. Not-for-profit managers must satisfy all stakeholders. For-profit managers are primarily concerned with satisfying owners.
19 2-14 Discussion Items What responsibilities do FP businesses have to stakeholders other than owners? Should FP businesses behave ethically? If so, why? What is a benefit corporation (B corporation)?
20 2-15 Financial Goals The primary financial goal of investorowned corporations stems from their organizational goal: shareholder wealth (stock price) maximization. The primary financial goal of not-forprofit corporations is to ensure the financial viability of the organization. Does the difference in financial goals lead to appreciably different behavior?
21 2-16 Tax Laws Some understanding of tax laws is necessary because taxes influence: Financing decisions The operating cash flows available to an investor-owned business The ability to raise contribution capital There are several types of taxes: Federal versus state versus local Personal versus corporate Ordinary income versus capital gains
22 2-17 Personal Taxes Individuals pay federal (and perhaps state) taxes on salaries, interest, and other income at rates that can approach 50%. (Capital gains and dividends [in some years] are taxed at lower rates.) Taxes lower the amount of useable income. Consider a person paying 40% in taxes that receives $100 in interest: AT amount = BT amount x (1 - T) = $100 x (1-0.40) = $100 x 0.60 = $60.
23 2-18 Corporate Taxes Investor-owned corporations pay federal and state taxes on corporate income at rates that can exceed 40%. Not-for-profit corporations, for the most part, are not subject to taxation. Not-for-profit corporations have two additional tax benefits: Can issue tax-exempt (municipal) bonds Can receive tax-exempt contributions
24 2-19 Taxable Versus Muni Bonds Assume FP Healthcare must offer a 10% interest rate on its new bonds. Jane Green, an individual investor with a 28% tax rate, buys one $1,000 bond. What is the effective (after-tax) annual interest? AT$ = (0.10 $1,000) x (1-0.28) = $ = $72. AT% = 10% (1-0.28)= 10% 0.72 = 7.2%.
25 2-20 Discussion Items Assume NFP Healthcare can issue similar-risk municipal bonds with an 8% interest rate. Should Jane buy the NFP bond rather than the FP bond? At what rate on the FP bond would Jane be indifferent between the two bonds? AT% = BT% (1 - T) 8% = BT% (1-0.28) = BT% 0.72 BT% = 8% / 0.72 = 11.1%.
26 2-21 Discussion Item Not-for-profit businesses generally are exempt from local property taxes and state and federal income taxes. Should policymakers mandate that not-forprofit healthcare organizations provide indigent (charity care) services equal to the tax benefits received?
27 2-22 Conclusion This concludes our discussion of Chapter 2 (Healthcare Business Basics). Although not all concepts were discussed in class, you are responsible for all of the material in the text. Do you have any questions?
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