University of Mississippi

eGrove
Touche Ross Publications Deloitte Collection

1972

Financing hospital expansion

Robert C. McCormack

J. Thomas Presby

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Part of the Accounting Commons, and the Taxation Commons

Recommended Citation
Tempo, Vol. 18, no. 3 (1972/73, winter), p. 23-26

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 To adapt to a changing medical environment, hospital
trustees and managers are continually striving to mod-
ernize existing facilities to provide new services. Usually
this modernization process evolves over a period of
years and only rarely does a hospital undertake a sig-
nificant capital expansion program. Consequently, when
it becomes necessary to expand, even the most experi-
enced and sophisticated hospital managements and
boards find themselves unprepared for planning, de-
signing, financing, constructing, and equipping an addi-
tion to their facilities. Since most hospital board mem-
bers serve in a part-time capacity and have careers of
their own which require attention, the careful and de-
tailed planning which should be completed before at-
tempting to finance and construct hospital expansions
often is not given sufficient attention.
A hospital's expansion program usually begins with
the observation that the historical utilization rate has
been high and therefore an addition to the bed-comple-
ment is needed. The parameters for an expansion plan
are then developed, reviewed, and adopted by the board.
Next, an architect is commissioned to prepare a set
of plans for the addition of a certain number of beds.
When the architect has completed his assignment and
estimated the construction costs, only then does the
board focus on the financing aspect of the problem.
At this point, the goodwill of the hospital board mem-
bers is called upon to assist in the financing. But how
often is an orderly examination of the financing alterna-
tives made with an analysis of the pros, cons, and costs
of each method?
Operating plans and projections are usually prepared
to satisfy the minimum requirements set by the favored
lender. But how often are such projections used in plan-
ning the expansion itself?
Heretofore, the unnecessary costs associated with
Student housing project completed recently at Research
Hospital and Medical Center in Kansas City, Missouri, cost such an ill-conceived expansion program have been re-
one-and-one-half million dollars. covered from third-party reimbursement agencies and

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private patients. In the future, however, attention will be ing medical practices must be carefully considered. The
focused on the health care delivery system. The wide trend to shorter average stays in hospitals and a greater
discrepancy in per diem costs among competing hos- reliance on outpatient care, for example, will certainly
pitals, the unnecessary duplication of facilities, and the have a bearing on future demand for hospital beds.
excess bed capacity that exists in some areas will be A hospital planning an expansion should also con-
recognized and no longer subsidized. To meet the chal- sider the availability of health care professionals and
lenge of providing the finest medical care at the lowest the institution's ability to attract a proper mixture of
possible cost, those responsible for the health care medical staff sufficient to generate the patient base-load
delivery system; doctors, administrators, boards of trus- for supporting the hospital's operations. Careful anal-
tees and various health officials; must be cognizant of ysis must be given to other institutions in the area to
the changing climate. determine the present competitive situation as well as
these institutions' future plans.
Basic Planning for Expansion
Thus far, the planning process has included;
As for any capital expenditure, proper planning of • identifying the service area,
hospital expansion depends on thorough investigation,
• analyzing the demographic characteristics of the
consultation, and review. First, an analysis of patient
service area,
records is necessary to determine the hospital's service
area. Next, the demographics of both the primary and • analyzing in detail the hospital utilization rates,
secondary service areas should be studied to determine • analyzing historical and anticipated utilization rates
the composition and trends of the population with regard and using them to project bed needs,
to age, sex, income distribution, and geographic loca-
• adjusting projected needs to reflect trends such as
tion. The U.S. Census reports are the basic sources of
shorter average length of stay and the shift to out-
this data, but significant supplemental data can be ob-
patient services,
tained from schools, utilities, and governmental plan-
ning agencies. • reviewing operations and plans of competitive in-
The historical utilization rates should then be ana- stitutions,

lyzed to determine how efficiently the existing facilities • determining the availability of desired medical staff,
have been used. This study should be conducted on
• synthesizing the above and determining the alloca-
a departmental basis and should include the ratio of
tion of resources (e.g., doctors, money) that can
beds per service area, the average length of stay per
best serve the needs of the community,
patient, the average daily patient population and occu-
• analyzing alternative methods of financing.
pancy rates, and the ratio of patient days and admissions
to total population. When the hospital's pro forma demands have been
After the basic data have been compiled, projected established, the needs can be translated into a facilities
utilization rates should be applied to the projected cen- plan. Using this plan, the construction and equipment
sus data to determine the expected demand for beds costs of the project can be developed and then the op-
and services, it is important to note that no standard erating and financial projections can be prepared.
formula can be used to project future needs, and chang- Financial projections consist of an analysis of the rev-

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 TYPE COSTS WHICH MAY BE TYPE OF MORTGAGE/ CERTIFICATE FEASIBILITY
AVAILABLE TO AMOUNT OF LOAN OF LOAN INCLUDED IN MORTGAGE TERM INTEREST RATE FEES SECURITY LENDER OF NEED STUDY
ALTERNATIVE METHOD

(I) Hill-Burton programs not applicable not applicable not applicable not applicable
non-profit hospitals set by individual state not applicable not applicable not applicable nol applicable not applicable
(a) grants
or public hospitals based on federal allotment

same as above except combined 25 years prevailing rate none first lien; will assume U.S. Government required where applicable, feasibility study
(b) direct loans public agencies or private construction construction and relat'ed costs may
HEW loan and grants cannot less 3% subsidy a junior position to otherwise project must by HEW
non-profit institutions able to issue and permanen je included; does not allow interest during
exceed 90% of project costs construction or any finance costs another federal loan conform to state plan
tax-exempt securities

25 years prevailing rate fee for placing loan first lien; will assume private required where applicable, feasibility study
(c) guaranteed loans non-profit hospitals same as above except combined construction construction and related costs may
less 3% subsidy that is negotiated between hospital a junior position to financial institutions otherwise project must by HEW
HFW loan and grants cannot and permane 3 included; does not allow interest during
exceed 90% of project costs onstruction or any finance costs and its agent another federal loan conform to state plan

non-profit hospitals determined by amount limited 25 to 40 years prevailing market fees and expenses first mortgage public debt market required where applicable, feasibility study
(II) Tax-exempt bonds constructk
where state laws permit and of debt hospital can carry ;he particular method rate for tax exempt bonds associated with a public underwriting and/or pledge otherwise project must by an independent
and permai
municipal hospitals Inancing, but would be a function of revenues conform to state plan expert
nospital's debt capacity

all types of hospitals function of amount construction ot limited 25 years prevailing market placement fees, first mortgage public market required where applicable, feasibility study
(III) Taxable first mortgage bonds
of debt lenders feel hospital and or perm? y the particular method rate for taxable bonds legal expenses, commitment fees, or private placement otherwise project must by hospital or an
can earn f financing, but would be a function and related fees with financial conform to state plan independent expert
hospital's debt capacity institutions

(IV) FHA insured mortgage 25 years coupon (currently 7%) set

construction up to 90% '/2% per annum insurance fee, first mortgage any FHA approved required from state feasibility study
(a) Sec. 242 FHA private non-profit $50 million by HUD; present market rate exceeds
and proprietary hospitals and/or permanen of the replacement cost FHA fees amounting to $8 per $1,000 lender Hill-Burton Agency by HEW
mortgage insurance and cannot exceed 90% 7%; effective cost raised by discounting loan
of mortgage of face value of mortgage, placement
of project costs to market rate; discount depends on whether fees, and related fees
loan is sold to private investors or FNMA

up to 90% 25 years same as above except that marketability GNMA application fee, government private investors
(b) Sec. 242 FHA insured mortgage same as above $50 million construction required from state feasibility study
of the replacement cost of GNMA securities results in a more favorable annual GNMA guarantee fee, plus fees guarantee and financial institutions Hill-Burton Agency
used as collateral for a Government except where indicated and cannot exceed 90% and/or permanen by HEW
of mortgage interest rate and lower discount associated with FHA method
National Mortgage Association modified of project costs
pass-through security

not limited up to 25 years not applicable but lease must included in lease package
(V) Lease financing all types of hospitals function of ability facilities not applicable not applicable required where state not required but
to any specific costs be approved by Blue Cross and
of hospital to support debt leased to hospit* law dictates a Certificate economic feasibility
other reimbursement agencies as meeting
of Need of project must be
reasonable cost criteria
clearly demonstrable

SOURCE: Dillon, Read & Co., Inc. and Touche Ross & Co.
enue and expense profile of the new facility as well as riod when salaries and fixed charges increase in ad-
an analysis of the anticipated cash flows and fund re- vance of increased revenue levels. Secondly, an in-
quirements. With the aid of computer simulation models, crease in working capital may be required to finance
the variables can be interchanged to answer questions the higher inventory and receivables level associated
concerning the effects of such situations as lower-than- with the increased plant facility.
projected occupancy rates. The expense projections are
What are the financing options?
constructed based on the given fixed costs (building and
equipment) plus the associated variable costs such as The range of available methods of financing will vary
staffing levels, the supply usage rate, and other items according to a hospital's geographic location, category
that can be adjusted within a certain range to match of ownership, and specific financial needs.
given levels of occupancy rates. The methods of financing health care facilities are
The revenue side of the profile is an extension of the continually changing as the federal government expands
estimated patient population multiplied by the schedule its existing programs and introduces new ones.
of charges. In developing the charges and fee structure, At present, there are five major financing methods
room rates cannot be merely adjusted to cover the available to hospitals. Although fund drives and philan-
anticipated costs for bricks and mortar. Even without thropic donations are an important aspect of hospital
Phase II price guidelines, reimbursement agencies are development, they are not included here in the category
taking a closer look at rate increases and make it in- of financing options. In any case, the major areas are:
creasingly important to justify price increases in terms Hill-Burton programs, tax-exempt bonds, taxable mort-
of need and operating efficiencies, rather than cost gage/bonds, FHA-insured mortgages, and lease fi-
levels only. nancing.
At this point, a pro forma income statement has been These basic alternatives, briefly described, are:
developed showing revenues less operating expenses (1) Hill-Burton Programs:
(excluding depreciation) and giving income available for • Grants for the construction and modernization of
debt service. Attention should now be turned to the nonprofit hospitals and public health centers,
available methods of financing. long-term care facilities, and outpatient and re-
The financing decision must consider three questions: habilitation facilities;
(1) How much should be raised? • Direct loans with interest rate subsidy available
(2) What borrowing options are open? to public agencies for the construction or mod-
ernization of public health centers and public
(3) How are the borrowing options evaluated?
hospitals, long-term care facilities, and out-
How much? patient and rehabilitation facilities;

The amount required to finance the expansion in- • Loan guarantees available to nonfederal lend-
cludes the obvious amounts to cover land acquisition, ers to secure the payment of principal and in-
building and equipment costs, offsite improvements, and terest on loans made to nonprofit private agen-
financing costs. In addition, there are two cash require- cies for the construction or modernization of
ments that must be provided for or assumed to be part hospitals, long-term care facilities, and outpa-
of the total financial needs. The first is "bridge financ- tient and rehabilitation facilities.
ing," and the second is "increased working capital." (2) Tax-Exempt Bonds:
Bridge financing is the amount of dollars required to • Issued by a state health facilities authority on
cover a negative cash flow during the construction pe- behalf of a nonprofit hospital,

25
 • Issued by a municipal corporation or hospital ment formulas must be considered. As Medicare regu-
district for a public hospital, lations currently stand, interest, expense, and deprecia-
tion are allowable costs for reimbursement purposes,
• Issued by a municipal health facilities board on
behalf of a nonprofit hospital, but payments for amortization of principal are not. Ac-
cordingly, if the depreciation allowance is the only
• Issued by a local industrial development author-
source of cash flow available to meet principal pay-
ity on behalf of a nonprofit health facility and,
ments, then clearly the principal payments must be
under certain circumstances, on behalf of a
geared to a project's schedule of depreciation. It would
profit-making health facility.
be poor business judgment to lower the amortization
(3) Taxable First Mortgage Bonds: schedule to achieve a higher coverage ratio if a provi-
• Sold publicly or offered privately by nonprofit sion were not made for the full amortization of principal
and for-profit hospitals. from allowable reimbursable costs.

(4) Mortgage Loans on nonprofit and For-Profit The next category to review is restrictions placed on
Health Facilities Insured by FHA: a borrower; e.g., restrictions pertaining to the mortgage
• Placed with a mortgage banker or the Federal lien, the assumption of additional debt, working capital
National Mortgage Association. requirements, lease obligations, sinking fund require-
ments, call provisions, and refunding protection. For
• Used as collateral for issuing a Government Na-
example, a hospital planning a $10 million expansion
tional Mortgage Association "modified pass-
program that expected a $400,000 Hill-Burton guaran-
through" security.
teed loan should consider seriously the indenture re-
(5) Lease Financing: strictions pertaining to this loan in light of the incre-
• Up to 100% financing that is fully reimbursable mental capital required.
by third-party payers. As a final element in considering financing alterna-
tives, the proposed time schedule for each method must
How Are the Alternatives Evaluated? be analyzed thoroughly. Construction costs are con-
In evaluating alternative financing methods, particu- stantly rising due to inflation, so the administrative re-
lar consideration should be given to analyzing the effec- quirements and time lag of obtaining an FHA-insured
tive cost of money, the terms of the loan, the covenants loan might cost more in the end than a private place-
or restrictions placed on the hospital's operations, and ment of debt securities which could be obtained quickly.
the timing from the planning stage through the comple- As the demand for expansion funds and the credit-
tion of construction. worthiness of hospitals has increased, hospitals have
The lowest interest rate (or coupon) does not neces- come to be analyzed as an industry. Many of the same
sarily result in the lowest cost of money. For example, quantitative standards that are applied to corporate and
under the tax-exempt methods, it is common for a re- municipal finance are being adjusted and applied to the
serve fund to be established that is equal to one year's hospital industry. As in other areas, the qualitative fac-
debt service (principal and interest). The annual debt tors of a business can have an important impact on the
service on a $10 million, 6%, twenty-five-year bond interest rate and terms of a loan. Behind the numbers,
having level debt service is $782,300. Assuming no other investors are seriously interested in the quality and
expenses (such as underwriting charges), the effective depth of the medical staff, the level of community sup-
cost of the usable monies would be 6.65%. port for an institution, and how well the hospital is man-
In analyzing the terms of the loan, existing reimburse- aged. •

26