Proposed CMS Changes to the Cost-of-capital Assumption: Analysis
For 2012, CMS proposed a reduction in the cost-of-capital (or interest-rate) assumption used in the development of the cost-of-equipment estimates that are included in the practice-expense component of the RVU calculations. Historically, CMS has used an interest-rate assumption of 11%. Based on the current prime rate and maximum interest rates for Small Business Administration (SBA) loans, the proposed changes would result in a drastic reduction of these rates to 6% (or less) for most types of major medical equipment. On the surface, it might appear that the cost of borrowing has declined over the past several years, but this concept is inconsistent with our experience in completing valuations for hundreds of health-care facilities and services since our inception in 1995. Further, the data for publicly traded health-care companies do not support a cost-of-capital assumption of 6% or less. The primary conceptual flaw presented by the CMS approach is the assumption that the cost of capital only consists of the cost of debt. The typical capital structure, for almost all business types, consists not only of debt, but also of equity. The weighted average cost of capital is a discount rate that takes into account the required rate of return necessary to justify investment, based on capital structure, prevailing economic risk, market risk, specific-industry risk, and specific-company risk. Cost of Debt Versus Cost of Equity The party lending debt capital to a business requires a return on the debt, which comes out of the business in the form of interest payments. Lenders have a higher claim against assets of a business and, therefore, are exposed to less risk than are equity investors. Because of the lower risk level, the cost of debt is less than the cost of equity. The interest payments also are tax-deductible to the business entity, which further lowers the cost of debt. Equity investors require a higher rate of return on their investments than do debt holders because their claims on a facility’s assets are secondary to those of the debt holder. In addition, a business entity is not required to pay dividends, whereas interest payments are usually fixed over the term of the debt. The weighted average cost of capital incorporates the claims of both debt holders and equity holders in proportion to their relative capital contributions (see box). The percentages of equity capital and debt capital are based on market value, not book value. The market value of equity, in particular, might differ substantially from the book value. While the percentage of average and median debt capital in the capital structure for publicly traded health-care companies in the VMG Index has increased from 30% to 50% between 2005 and 2011, our experience in valuing over 1,000 health-care businesses during this time is that the percentage of debt in the capital structure for most of these businesses ranges from 20% to 30%. Single-location health-care businesses do not have the same access to debt capital as the larger and more diversified publicly traded companies included in the VMG Index. The Real Cost of Capital While we might also consider other approaches, such as the capital asset pricing model, to develop a weighted average cost of capital, we typically rely on a buildup approach (see box) to estimate the equity portion of the weighted average cost of capital for a business in the health-care industry. In addition to the conceptual issues associated with the CMS approach, which only considers debt, the data for the inputs used to calculate the total cost of equity and the cost of debt do not suggest that there has been a substantial decline in the weighted average cost of capital—or even in the cost of debt. While there have been very slight declines in the risk premiums associated with the market and small companies, there has been an offsetting decline in the negative adjustment for the health-care industry. Further, the cost of debt since 2005 for publicly traded health-services companies included in the VMG Index has been very minor, in comparison with the change in the prime rate. In summary, we believe that the current methodology for calculating cost of capital, as proposed by CMS, understates the real economic cost of capital because there is no consideration given to the cost of equity. In addition, while the prime rate used to calculate the interest rate on SBA loans has, indeed, declined substantially since 2005, the reduction in the negative adjustment for the health-care industry more than offsets the impact of any minor adjustment in the other factors. While imaging centers are unlikely to have seen any reduction in the weighted average cost of capital (or even, perhaps, in the cost of debt), the proposed reduction in the interest-rate assumption will, in turn, result in further reductions in Medicare reimbursement. Todd J. Sorensen, AVA, is a partner with VMG Health, a national company that specializes in health-care valuations and transaction advisory services.