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Indian Institute of Management, Kozhikode Strategic Financial Management

Hospital Corporation of America

Group 1-Section A| Case Submission
Kavadi Omprakash* Abhishek Bhalotia Divesh Ranjan Rithika Baruah Saurabh Pillai Siddhartha Roy (PGP/15/226) (PGP/15/263) (PGP/15/275) (PGP/15/313) (PGP/15/318) (PGP/15/321) 15% 20% 20% 10% 20% 15%

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1. Assess HCAs performance and business strategy. How are these likely to change in the future? Specifically, what is the likely impact of the proposed change to prospective reimbursement by Medicare/Medicaid programs? More generally, should HCA push for maximum growth, or slow down and focus on increasing profitability? HCAs strategy is largely linked to achieving annual growth of 25-30% (including inflation effects) for several years in the future. It has largely grown in the recent past by means of acquisition of existing hospitals, construction of new hospitals and acquisition of other proprietary hospital management companies. However, in the future, especially with regulatory changes in the pipeline, HCA might have to shift its focus from growth to profitability. Considering the prospective reimbursement by Medicare/Medicaid programs, a hospitals profitability (or even survival) would be linked to cost of services provided. In such a scenario, growth (especially by acquisition) would have very high investment costs which would put a lot of pressure on HCAs return on investment. Therefore, in light of the upcoming prospective reimbursement regulations, it would be prudent to consider slowing down and focusing on profitability instead of growth.

2. How does HCAs financial strategy affect its product-market strategy? How important is finance to HCA? In what ways? HCAs financial strategy would affect its growth strategy since acquisitions as well as new construction of hospitals have very high investment costs and covering these costs need sufficient debt for the project see the light of day. The debt ratio also affects the efficiency of HCA in raising funds in the capital market. Undoubtedly, finance is very important to HCA as is evident from the composition of its board of directors. Its debt ratio is crucial in how it grows as well as the way it copes with the anticipate regulatory changes. In addition, HCAs earnings per share affect its profitability and stock performance.

3. Evaluate HCAs set of financial goals. Are they achievable as a group? Which are most important and why? How might HCAs debt policy affect its ability to achieve these goals? How might it affect HCAs ability to raise funds in capital markets?

HCAs set of financial goals include maintaining a debt to total capital ratio of 60% (the number was arrived at by a rather informal method and continued to stay there due to conservatism), return on capital was expected to stay around 11% after taxes, return on equity around 17% after taxes and dividend payout of 15% of net income as well as maintenance and improvement of net profit margin as a percentage of operating revenues. In addition, the CFO wanted the average interest cost of HCAs debt at 15% or lower. Among these, the most important goal was to deal with the debt ratio. Since the 60% figure was arrived at during HCAs initial years by downsizing from the average debt for real estate development projects, there was a lot of speculation that it might be a very small number. It was argued that the debt ratio should be maintained to be as high as 75%-80% to accommodate HCAs growth strategy in the future. The availability of debt would be helpful in acquisition and construction projects to achieve the required growth. However, an increased debt ratio would lead to a drop in HCAs credit rating. This would lead to a limitation in raising capital via bonds. Moreover, 60% might be a high number considering the potential changes in the regulatory environment. 4. Should HCA be concerned about the possibility of losing its single-A bond rating? How does HCAs rating compare to its competitors bond ratings? In general, how much importance should a company attach to credit ratings when establishing a target debt ratio? What are the consequences of too much or too little leverage for HCA? The current debt ratio of HCA is 70%much higher than established target ratio of 60%. In order to maintain the rating of A, HCA has to maintain its debt structure of 60-40. The concern associated with losing the rating is the amount of debt holding. With more debt under the hand the position can be leveraged for investing in future growth of the company. Some investors believe that a more aggressive use of leverage would present greater opportunities in the future. Others feel that with changes in Medicare/Medicaid reimbursement structure on the horizon, HCA should remain conservative.

HCA belongs to the construction industry and the general trend in this industry was high debt, even up to 95% of debt was acceptable norm. However, HCAs assets included


equipment rather than buildings or plants. So going by conserving attitude 70% of debt was acceptable. Companies dont pay much attention to the credit rating while establishing Debt/Equity ratio. Rather the company determines the appropriate amount of debt popular in the industry and customizes it to own requirement. There are two alternatives: Scenario 1: Maintain current debt ratio of 70%.

This would also indicate that HCA receives a lower rating. This could prove to be good and bad. In some instances, companies with lower ratings experience a rise in their cost of debt or loss access to the debt market. But with growth rate of 15% and ROE of 17.6% signifies efficiency and company is headed in right direction. Loss of the A rating could make the access to the debt markets difficult. Scenario 2: Reduce debt to equity ratio.

If HCA decreases their debt ratio to 60%, they will retain their A bond rating in exchange for a decline in their ROE and growth rate. 5. What is the order of magnitude of HCAs funds over the next few years? Are these needs deferrable? HCAs growth objective implied capital expenditure of $575 million in 1982. This level could be expected to expand by 20% a year for the next several years. HCA would like to see the annual growth rate in the 25-30% range, although they have also set a minimum of 13%. The debt payment can be deferred in the current scenario but we believe that interest coverage and debt coverage ratio is quite adequate in order for the payments to be made at the original schedule and therefore, there is no additional benefit derived out of withholding the debt payments. 6. Outline the key components of financial strategy and policy for HCA. The broader strategic and financial goals as specified by Hospital Corporation of America are as follows: a. Financial Objectives for Hospital Corporation of America: o Minimum Pay-Out Ratio: 15%

o Target/Original Debt to Equity Ratio: 60:40 o Cost of Debt <= 15% b. Growth Rates being targeted is equal to or greater than 13% in real terms or 2530% in nominal terms adding the inflation effect onto the growth rate. Since the maximum retention ratio can be 85%, minimum RoE can be calculated using Sustainable Growth Rate Equation, which will give Required Return on Equity= 32.35%, which is in excess of current Return on Equity (23.7%) ROE (Current) is lesser than nominal ROE that will be required by Hospital Corporation in order to keep the growth rate at 28% as desired. ROE can be increased either through increased leverage or increase in the return on total capital. Minimum Return on Equity in order to sustain 32.35% has to be arrived at and therefore, HCA needs to be aggressive in its financial strategy. Also, the current interest rate as per the calculations derived from Exhibit 5 suggests that there will not be any significant deviation (10.54% compared to 11.54% with BB bond). Thus, HCA must be aggressive in financial policy. Since there will not be any significant increase in cost of debt with downgrade in bond ratings, target bond rating must be BB (Cost of Debt: 11.54%). Maximum Return on Capital amongst all the comparable organizations currently is 14.26%, which can be assumed to be the best possible, due to improvement in operational parameters. We can assume the return on capital to be average of current return on capital and maximum return on capital (i.e. 13.02%). Using the data, Debt to Equity Structure should be equal to 76:24 in the capital structure. Since there will be additional capital expenditure to the tune of $575mn in 1982, equity capital will also be required to be raised to the tune of $ 128.48 mn for maintaining the capital structure. The choice between fixed rate and floating rate bond will be contingent upon the capital market conditions. However, using the current schedule of outstanding debt, LIBOR Rate comes to be around 8.2%. For maximum cost of debt equal to 11.54%, the ratio of fixed to floating rate must be equal to same ratio as the one prevailing in the current debt structure. Cash Flow to Debt Coverage Ratio for HCA stands at 5.34 for FY 1982 even at current earnings level i.e. ignoring the growth in earnings that will occur in the next year. The same is applicable further, for the next five years as well. Therefore, HCA must retire the long term debt for the next five years as per the original maturity schedule.


7. What specific financing action would you recommend that HCA implement in January 1982? As already discussed in the previous question, there will need to be equity capital infusion along with issue of new debts for HCA in order to maintain an aggressive debt to capital ratio of 76%. Debt coverage ratio for HCA remains fairly comfortable at 5.34, even at the current quantum of earnings. But given the current market conditions, with equity stock price being significantly undervalued in comparison to the current conditions, amount raised through equity issue will be low and there will be unnecessary corrosion of EPS, leading to excessive, avoidable dividend pay-outs. Therefore, for meeting the US $ 575 mn capital expenditure requirements for FY 1982, we recommend that the entire amount be raised through issuing 25 year debentures at rate of 16.5%.