Midterm Deck - Sessions 1-7 Flashcards
Capital Definition
The residual value of our economic activity. People with claims to residual value become wealthy.
Finance Definition
Cashflows, capital markets, the flow thereof
Financial Accounting Definition
accounting done for an external audience, must follow clear rules (FASB, GAAP)
Accounting Definintion
• Accounting:
o Budgeting, is firm specific.
o Takes what’s opaque and makes it known to the outside world
o Is critical for the functioning of democracy and the for-profit sector.
Managerial Accounting Definition
Accounting for an internal audience; is for internal purposes only.
What is it not uncommon for firms to do between managerial and financial accounting?
To follow separate rules for each type of accounting.
Other names for Cash:
aka “electronic funds”, aka “M1”.
3 nuances of cash
Every firm must have access to a steady flow of cash
• Even rich firms can die for a lack of cash
• Firms guarantee cash by having a close relationship with a bank (i.e. “commercial paper”).
Other name for debt
borrowed money
Nuances of Debt
- Can take the form of a bank loan, but banks don’t like to put too much of their own money into one borrower.
- Low risk/low return instrument.
- Is traded and created in public debt markets
- Can be securitized or unsecuritized
- “Firm specific” collateral is a challenge; collateral only has value if it can be resold, and so may not offer much protection if the collateral is such that the lender cannot resell it in case of loan default.
- Credit Card debt is considered unsecuritized
What claim do creditors have on debt?
a first-order legal claim on all residual assets.
What is the purpose of capital markets?
To distribute risk.
Othername for equity
stock
Nuances of Equity
- In healthcare you see it often for durable medical equipment and new drugs
- Carries with it a concept of ownership; the holder of equity effectively owns a percentage of a firm’s revenue
- What we pay for the stock depends on what we think the firm will make in profit in the future
- Only control as much of the firm as you own by percentage
- You can have up to 100 owners of a firm before you must IPO
who can purchase equity?
- Private investors
- Private equity
- Angel investors
- Venture capitalists
3 types of capital
cash, debt, equity
Things that can lead to Market Failures
Public Goods, Externalities, Imperfect Information
What is a market failure?
When capital access and capital need don’t match up
What is a public good?
- buyer of good is forced to share the utility of the good with all others
• i.e.: a lighthouse provided by the government, defense, public security
• Education and Health are both public AND private goods
How are public and quasi-public goods financed?
• Public and Quasi public goods are handled through public funding.
Money for public funding comes from:
• Taxes
• Public Finance (borrowed via the debt markets)
• A Public Authority,
What is a public authority and what can it do?
which is a quasi-governmental agency with a board of governors; it can float debt independent of area government (so has tax-free access to the public debt markets)
o i.e. Port Authority of NY and NJ
o “Hospital Construction Bonds”
o “Dormitory Construction Bonds for Public Universities”
What is an externality
when you create costs for someone besides yourself
• i.e. cars that spew pollution, painting your house an ugly color
• can “charge” for externalities through public shaming, etc.
What is imperfect information?
Asymmetry of information between two sides of a transaction is rampant in health care. Its why healthcare markets fail and why we have regulation.
What does the ACA try to do
requires young, healthy people to pay too much for HC – is a social cost/contract. It’s a way to achieve social equity in finance, and redistribute wealth.
Healthcare Cashflows and Funding Mechanisms
o Cash – i.e. money people spend at CVS!
o Taxes – a huge amount of taxes (payroll) flow into provision, construction, training and research for HC
o Hospital Construction Bonds – are tax exempt to lenders
o Owner’s Equity – in for-profit hospitals, pharma, clinical practices
o Venture Capital – have recently seen venture capitalists buying orphan drug patents and pushing them through to get approval
o Philanthropy – historically a great deal of capital in HC has come from philanthropy. This has largely declined as hospitals became less dependent on this (are now more insured, have better access to debt markets, etc.)
Health Insurance is a form of a
generational cost shift
• Its true that on an individual basis “you never know”
• But it’s also true that as a whole, we do know – your health will get worse as you age.
• So, we over pay when we’re young so we can under pay when we’re old
• You’re effectively smoothing out your cost of care across your whole life (consumption smoothing)
• Yes, its redistribution, but its personal redistribution
risk distribution as per health insurance
Most people won’t draw down on their health care policy, but some do. So, the risk is distributed across all the policies in the pool.
risk aggregation as per health insurance
as policies are priced, companies try to assess individual risk (age, pre-existing conditions); so, we group ourselves (group policy) so that the group policy will be cheaper than the individual policy.
what is the crux of the ACA?
is the creation of artificial groups – by getting more people into the pool, risk is distributed (so it’s not just the sick buying in)
Prepayment
- we use it to prepay predictable costs.
- Was born out of corporate health plans
- Use it as a form of catastrophic protection
what does it mean when you go public?
offering an equity stake to the public
Profit =
= Revenues - Expenses
What is a budget?
o plan for a flow of funds (revenues + expenses) over a period of time (typically one year).
What factors are taken into account in planning a budget?
o It flows according to the organizational Mission (if non-profit) and its strategic plan (3-5 years out)
How is the budget a political document?
- It’s a compromise between constituents
- A good budget process goes through a variety of drafts
- Senior director calls for submissions from all departments, and its up to the manager of that department to justify its budget request
- ED then reconciles this and creates the budget
Name 3 types of budgets
- Master Budget (most senior budget)
- Operating Budget
- Financial Budget (aka Capital Budget)
What does the Operational Budget Do, and what types of costs does it include?
• Tracts organizational operations – what does it cost to keep the doors open? Includes: o Labor costs o Supplies and materials o Utilities o Administrative Costs
What type of accounting is used in an operational budget?
• Is accounted for on a cash basis
What do financial budgets/capital budgets include?
• Includes: o Equipment o Plant/Site Costs o Real Estate o Basically big long term fees
What type of accounting is used in financial budgeting?
accrual accounting
Accrual accouting is when
o You consider a value to be spent when an item is actually used (not when it’s purchased)
Cash accounting is when
You consider a value to be spent when the item is purchased (when the cash leaves our wallet)
When is it fair to use accrual accounting?
• Fair to use for goods that retain their value for a long time, and have secondary value
liquidity
how quickly can I turn this asset into cash
What type of budget do most firms use?
a modified cash budget
o Small things are charged immediately
o Bigger items are financed and discounted for on an accrual basis.
o At the end of the year you reconcile the budget and see how close you got to the budget on your actual spending.
How are most capital goods purchsed?
o Most capital goods are not purchased in cash – most are financed → must have confidence that this capital acquisition will add enough value to be able to service the debt
When do you realize revenue and write down expenses?
- Realize revenue: no solid rule, but generally you follow the cash
- Write down expenses: depreciation! First cousin to amortization. Depreciation is when an asset loses value as it gets old.
When you decide to “write off” bad debt is a…
management and pr issue.
Non-Discretionary Cost
Costs you need to spend to keep your doors open
o For most of us, the single largest non-discretionary cost is housing
Discretionary Cost
Costs that are wiggle-room able!
o I.E. Food, though necessary, does have wiggle room.
o Clothing may or may not be discretionary
Windfalls
Unexpected 1 time income
where does long term investment in infrastructure typically arise from?
strategic plans
What is each year’s budget typically based upon, and what is the problem with that?
• Typically each year’s budget is based upon last year’s budget
o Problem? Basing Budgets on previous budgets can lead to sticking with things that don’t work, just because.
Where do costs come from, organizationally?
o Salaries are clear (its obvious what department in which someone works)
o Utilities can be analyzed by square footage
o In HC, Nursing is ambiguous – can be its own department, but may be distributed amongst departments.
What is debt service?
The carrying cost of financing (principal plus interest per year).
What are variable aka direct aka operating costs?
- Is a cost that can intuitively be ascribed to a particular source of revenue
- Types include: per unit of production costs, labor (labor can be step-wise direct for every certain number of units produced)
what are indirect aka fixed aka capital costs?
- Is a cost that cannot intuitively be ascribed to a particular source of revenue
- Types include: Rent, utilities, equipment, tables, chairs, dishware, trays, codes/regulations/etc., intellectual property
- May over time allocate indirect costs on a per-person basis (i.e. per customer charge of 1/50th of a plate since every 50th customer breaks a plate on average)
Break-Even Quantity
(Fixed Cost)/(Price-Variable Cost)
How long it takes to recover your fixed costs
Beyond this quantity, all income is profit.
Full Cost
= Direct Costs + Indirect Costs
Average Cost
(Fixed Cost)/(Fixed Volume)
Marginal Cost
What does it cost you to produce one more unit?
o Its harder to do this in a service economy (i.e. cost of next patient, client, etc.) → % of staff time, % of legal, many considerations in the calculation!
Relevant Range of Fixed Costs
o i.e. restaurant has a set amount of tables it can buy in one space…however if they expand next door they’ll have to buy more tables. So, it’s the range of sales for which the fixed costs are fixed, before there is a stepwise increase above which fixed costs can increase substantially
o the range of values for which fixed costs are actually fixed.
What costs are not ultimately variable?
examples of costs that are not are intellectual property (computer code, screenplays, art, etc.). You pay “rent” on intellectual property.
Industries with High Fixed and Low Variable Costs
- Movie Theatre
- Airline
- High-tech Manufacturing
- All have a high barrier to entry.
Companies with low fixed and high variable costs
- Law Firm
- Consulting Firm
- Catering Company
Companies with Low Fixed and Low Variable Costs
- Landscaping
- Cleaning
- Don’t see consolidation here because these companies have low economies of scale
Companies with High Fixed and High Variable Costs
- Hospital
* Autoplant
Company with Medium Fixed and High Variable
Mechanic
Market Saturation
When all the easy customers are taken, and costs to attract the next customer grows more and more with each customer.
Rarity/Forced Scarcity
if what you do/produce has a reputation for scarcity (in materials/labor), it allows you to keep your prices high → forced scarcity. (think pediatric neurosurgeons)
Salvage Value
is the estimated resale value of an asset at the end of its useful life. Salvage value is subtracted from the cost of a fixed asset to determine the amount of the asset cost that will be depreciated. Thus, salvage value is used as a component of the depreciation calculation.
Lemon
Information Asymmetry can impact salvage value; transaction costs are taken into account due to the risk of this. A way around buying a lemon is to lease the car!
Loss Ratio
Loss/(Total Revenue)
Cost Basis
• Cost Basis: Criteria of how to allocate costs
Direct Cost basis
o Direct: Allocate Costs to Mission Centers
Step Down Cost Basis
o Step-Down: Push costs to the client/patient level (for profit world tends to do this) → you do this when its logical to do this.
• Universities might step down grant office indirect costs and academic services space…but wouldn’t step down commencement, etc.
activity based costing
how much does each activity itself cost (i.e. for every x-ray taken, how much labor, electricity, etc.)
Classic Fixed or Direct Cost Example
Help-line for clients
Budget Variance
How much over or under budget expectations costs actually come in
Volume Variance
difference in sales (expected vs. actual)
Rate Variance
costing estimate variation (expected vs. actual)
Usage Variance
Production process variance, labor, supply variance
Taylorism
How to reduce inefficiency. (i.e. can we make people like automatons? IT systems focus on this).
Underwriting process
o Underwriting process: A syndicate of banks (the lead managers) underwrites the transaction, which means they have taken on the risk of distributing the securities. Should they not be able to find enough investors, they will have to hold some securities themselves. Underwriters make their income from the price difference (the “underwriting spread”) between the price they pay the issuer and what they collect from investors or from broker-dealers who buy portions of the offering.
Private Equity
gets in later, when a revenue stream is already there, and there is a modest profit; short term strategy, always looking for exit strategy. Not buy & hold.
Venture Capital
interested in new startups; high chance of failure, but every so often can hit it out of the park. Gets in early on in the biz lifecycle.
Commercial Paper
(ST borrowing by both for profit and nonprofit agencies)
Certificate of Deposit
Locks you in for 30-90 days and you get a higher rate of return; is consumer access to commercial paper)
Commercial Bank Lending
Low Risk Loans, Collateralized Loans, tend to lend locally to mature businesses (used to have savings and loans)
o May lend to very safe businesses (i.e. a franchise)
o Or to professional practices (doctors, lawyers, will look at ficos and past exposures to make a call)
Bond Issuance
o Underwritten by Underwriters
o Not collateralized
Financing
The whole decision of how you get your hands on capital –> price is the major consideration
Definition of Rent and what can you do with it
time value of capital, the time value of an asset
o Allows you access to an asset for a certain period of time
o Can “rent” real estate, but also money, by paying interest (because money is an asset).
Discounting
).
• Discounting: take the money we will have in the future and see what it is worth today.
PV =
PV = FV/〖(1+r)〗^T
Historical Rate of Capital Return
capital return is 7-8%
Compounding
When we have the money today and want to know what it will be worth in the future.
FV =
PV*〖(1+R)〗^T
To compound for different periods of time
divide R/# of periods and then multiply T*# of periods.
Annuity
Financial Instrument with a series of repeating payments over time
o The repeating payments are called a coupon
PV = C*[(1- 1⁄(1+r)^T )/r]
Perpituity
An annuity that goes on forever
o PV = C/R
IRR
Internal rate of return → what does the company do with the money you borrow? It’s the aggregate interest rate of return on money. Is also the way of comparing the opportunity cost of capital.
Risk Premium
What extra return are you offering over other investments? And does it make up for the additional risk?
ten year treasury bond is called a
t-bill
How do you calculate the present val of a bond?
• Can think of a bond as both an annuity (of the coupon) and a future principal payment, and calculate the present value of the bond by summing both the present values of those two things.
