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Healthcare Business Basics
Chapter 2
8/1/12
ANSWERS TO END-OF-CHAPTER QUESTIONS
2.1 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
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2-1
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.
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2-2
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)
= $1,000,000 × 0.70
= $700,000.
b.
AT = BT × (1 − T) = $10,000 × (1 − 0.15)
= $10,000 × 0.85
= $8,500.
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2-3
Chapter 2
2.2
Healthcare Business Basics
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 = 0.105 = 10.5 percent. Alternatively,
AT = BT × (1 − Effective T) = $100,000 × (1 − [0.30][0.35])
= $100,000 × (1 − 0.105)
= $100,000 × 0.895
= $89,500.
2.3 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.
2.4
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.
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.
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2-4
2-1
CHAPTER 2
Healthcare Business Basics
Concept of a business
Legal forms of business
FP versus NFP ownership
Organizational goals
Financial goals
Taxes
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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?
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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?
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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
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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
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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
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2-7
Hybrid Forms of Organization (Cont.)
Limited liability company (LLC)
Members are taxed like partners
Liability like stockholders
Professional corporation (PC) or
professional association (PA)
Owners have benefits of incorporation
However, still liable for malpractice
Often used by individual clinicians
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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?
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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
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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.”
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Not-For-Profit Corporations (Cont.)
 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.
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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?
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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.
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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)?
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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?
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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
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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.
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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
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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)
= $100 × 0.72 = $72.
AT% = 10% × (1 - 0.28)= 10% × 0.72
= 7.2%.
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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%.
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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?
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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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