The Non-Profit Hospitals Weighted Average Cost Of Capital

Not-For-Profit (NFP) organizations, particularly NFP hospitals, have a fundamental problem with
their financial decision making process. These organizations have warm-hearted managers and
staff members, both volunteer and paid who only want the best for their organization and its
cause. However, studies have shown that NFP hospitals are spending unsustainably and are
finding themselves in financial ruin. This is stemmed from a few different causes but the
primary sources are these organizations inaccuracy and more importantly their unwillingness
to properly calculate the cost of capital when making investment decisions. In this paper I am
going to be realizing the causes for confusion regarding the cost of capital and I will be
identifying the need for policy change by NFP hospitals. Participating in the debate over NFP
cost of capital estimation and the need for a shift in policy, I will weigh in on the topics and
provide a channel for future debate with the hope for an eventual solution.
The WACC, as defined by Rakesh Duggal and Michael Craig Budden, is the average rate of
return required by suppliers of capital (lenders and shareholders). This is also the rate that an
organization must require from all its investments in order to maintain the organizational
value. (Duggal and Buddan, 1) For an organization to sustain operations, it must calculate this
number accurately or it risks overvaluing its WACC and rejecting otherwise good investment
decisions or worse, under assessing it and taking on investments, which fall below the
organizations, minimum needed rate of return. This would detract from value and, if done
continually, will ultimately bring the organization to insolvency. As one may already know, the
WACC for a public company is fairly simple to calculate. Traditionally comprising the sum of
three main sections of the organizations capital structure, the weighted after tax cost of debt,

the weighted cost of preferred equity and the weighted cost of common equity. The common
equity segment of this equation has traditionally been calculated using the capital asset pricing
model or the CAPM.
(Equation-1)

%

%

%

= ( ) (
) + ( ) ( ) + ( ) ()

Referring to Equation 1, although this equation is straightforward when discussing the WACC of
a For-Profit, public firm, it is another issue entirely to accurately calculate for that of a Not-forProfit organization.
Not-For-Profit hospitals have no tax on their debt and generally have no effective tax at
all so the tax on debt would be removed first from the equation. The real crux of the problem
with calculating for a NFP is however the fact that NFP organizations have no equity holders.
Instead all well-established NFP firms capital is held in its fund value. The fund is the
investable money that has been given to a NFP organization through donations, grants, and
other philanthropy. The logic behind the following calculation is based on the economic
principal of opportunity cost. The scholars, discussing the subject are attempting different
methods of identifying what the nonprofits fund could be earning if it were invested in
something other than the healthcare of the needy. As instructed by many scholars in the fields
of finance and economics and best captured in the Journal of Business & Economics Research,
Rakesh Duggal and Michael Craig Budden state,
Estimating the cost of net assets is challenging since its equity (net assets) is not publicly traded. In the absence
of freely available information, a similar, publicly traded firm is often employed as a proxy for the private firm in

empirical research. Following this approach and using the Capital Asset Pricing Model (CAPM), the for-profit
hospitals beta can be used as a proxy for the non-profits beta This beta should be unlevered and then adjusted
for the non-profits financial leverage (Duggal and Budden, 3)

The use of a proxy company for this calculation is a very cumbersome method to calculate
the WACC for a NFP and should be only acknowledged as an estimation of the real number,
rather than a true and hard calculation. Unfortunately, it is the most accurate method available
to estimate the WACC for a not-for-profit firms net assets. Since the method for calculating the
WACC is so imprecise, many hospitals have been found to only calculate the WACC based on
the rate of debt financing (the only truly known rate), completely disregarding the required rate
of return for their fund and therefore causing an injustice to the openhearted philanthropists
who deserve to see their money devoted wisely to the cause. When the NFPs disregard what
amounts to be on average more than 80% of NFPs capital structure is not only a disgrace to the
worlds philanthropists, but is more importantly an unsustainable proposition. Herein lies the
problem, there has been much discussion over the years in the field of finance, regarding how
health care nonprofits should calculate the cost of capital, yet it appears the work has been in
vain. Many healthcare nonprofits disregard the above method and many nonprofit healthcare
institutions are suffering subsequently.
In 1991 the American Medical Association came out with an article entitled More non-profit
hospitals facing financial troubles. This article discussed the amazing and growing
phenomenon of hospital municipal bonds defaulting and falling into junk bond territory by the
credit rating agencies. The author Howard Larkin says, Increasing numbers of troubled
hospitals risk defaultAbout 6% of the nearly 1,200 hospitals issued S&P rates are below

investment grade --- considered by banking regulators to be too risky for commercial banks to
buy. Five hospitals are rated CCC, one step above default. In 1983, only 3% of hospitals issues
were below investment grade. (Larkin, 1) These numbers increased through the 1990s and
although the recent financial crisis has clouded the true picture in our economy today, it is still
very relevant today that non-profit hospitals have fiscal issues they must contend with.
In order to impact the non- profit healthcare sector from a finance perspective I believe we
must think as a non-profits management would. These organizations and their leadership dont
reason in the same rational way as their for-profit counterparts. Although management does
not think in the same rational way as for-profits, they are still thinking rationally. While the forprofit organization seeks to maximize profits for their shareholders, the not-for-profit is trying
to maximize societal benefit to its focus segment of society. This may lead a non-profit to view
its fund as free money given to it for the furtherance of society, however; Uwe E. Reinhardt,
says in his article The Economics of For-Profit and Not-For-profit Hospitals from the journal of
Health Affairs that,
it may be argued that to match the returns that the for-profit hospital earns for society at large on equity
financed assets, the sum of profits retained by the hospital and the monetary equivalent of the unrequited
community benefits it provides the community should be equal to the monetary rate of return that for-profit
hospitals earn for their suppliers of equity capital (Reinhardt, 184-185)

This statement given by Reinhardt reinforces the most agreed upon method of calculating
WACC. It shows that the NFP should try by every measure to match the performance of its forprofit counterparts. Reinhardt continues by adding,

 To many champions of the nonprofit sector, it will not be obvious that $100 worth of community benefits
rendered to poor, uninsured patients can be equated with $100 worth of monetary benefits bestowed on the
often wealthy shareholders of a business corporation economic efficiency ought never to be pursued blithely in
abstraction from distributional effects. Taking into account distributional effects, however, makes determining the
proper amount of community benefits owed by nonprofit hospitals an inherently political issue. (Reinhardt, 185)

Here, Reinhardt identifies what I consider to be the main problem on this subject. Should
government get involved in the way that nonprofits identify the benefits they offer society or
should we continue to let non-profits calculate there cost of capital without economic regard
for their responsibility to society? If the finance field cannot even offer an exact method for
calculating nonprofits WACC, should we expect these organizations to comply with the
standard? The field of finance and policy has been unable to answer this question and
henceforth has been unable to convince nonprofits that the WACC should be calculated a
certain way in order to maintain economic sustainability. We must find a way to calculate this
number for NFPs and then promote it to and from within the healthcare field.
Many articles have been written to endorse the way NFP organizations should calculate
their weighted average cost of capital using the for-profit proxy method, there have been
statistics clearly indicating that NFP hospitals are having economic problems surrounding the
importance they perceive finance and managerial accounting to be to their organization, yet
these organizations continue to disregard the data and operate with little regard for the
economics behind their operations. One thing the Finance profession could do for the nonprofit
industry is to offer a concise solution to this economic inaccuracy. If a discrepancy of this
magnitude were identified in the for-profit sector, there would be nobeloriate economists

fighting to solve the problem, however, since we are discussing an inaccuracy in the world of
non-profits, the finance industry only offers a piecemeal repair for the problem. Furthermore,
the finance sector and the policy segment could publish more convincing material regarding the
negative effects on NFPs and more importantly the injustice any miscalculation would cause a
nonprofits target segment in society. These organizations will not react to the traditional profit
based motivations and instead need an explanation based on the injury caused to its charity
clients. In addition to this educational assistance, the finance field should offer this problem,
the government could offer solutions through policy initiatives. To this point and echoing
Reinhardts idea I feel that the value of charity or uncompensated care could be set at rates
established by some government institution or by Medicare. Since this calculation has some
merit on the national health system and does have some relevance with our nations recent
healthcare structure and the cost problem that we have seen over the past few decades leading
up to the Affordable Care Act, it may befit our congress to enter into a congressional study on
this topic and others distressing the NFP sector. The troubles surrounding the American
healthcare system deserve the highest level of attention from government, it is a matter of
national stability that we heal our healthcare segments fiscal woes.
Throughout this paper, I have shown the reader that there is a problem and inconsistency with
the way non-profit healthcare organizations calculate their weighted average cost of capital, I
have shown that over the past few decades and especially during the 1990s generally accepted
to be a period of economic prosperity, the healthcare segment has been suffering fiscal woes
likely due to their lack of attention to finance and managerial accounting, and I have shown that
the field of finance has done very little but accept the status quo in regard to this issue. It is

time for the finance field to wake up and help solve this discrepancy in their field. It also time
for Washington to fund research to help the field of finance repair this and similar issues in the
NFP segment of our economy. If this simple calculation were to be both perfected and
promoted within the healthcare realm, we would likely find hospitals that are able to care for
their patients at lower cost while offering more in the way of charity care to their target
patients. It is simple obstacles such as these which offer limits to the amount and quality of care
Americans can receive in our nations hospitals, hopefully, a solution can be found.

Works Cited
Duggal, Rakesh; Buddan, Michael. Assuring Not- For- Profit Hospital Competitiveness Through
Proper Accounting For The True Cost Of Capital. Journal of Business and Economics Research
8.11 (2010): 1-6. Web.

Reinhardt, Uwe. The Economics Of For- Profit and Not- For- Profit Hospitals. Health Affairs
19.6 (2000): 178-186. Web.

Larkin, Howard. More non-profit hospitals facing financial troubles. American Medical News
34.27 (1991): 7. Web.