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##### Case Study 13 - Southeastern

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A. What is the market risk of each project (A and B) relative to the aggregate market of SSI? (For this question, assume that SSI is an investor-owned company.) No additional calculations are necessary.;B. What is the corporate risk of each project (A and B) relative to the aggregate corporate risk of SSI? No additional calculations are necessary.;A. What is the efficient markets hypothesis (EMH)?;B. What impact does this theory have on decisions concerning investments in securities?;C. Is the EMH applicable to real asset investments, such as the decision of SSI to invest in Project A or Project B?;D. What impact does EMH have on corporate financing decisions?;********************************************************************;S O U T H E A ST E R N;S P E C I A LTY, I N C.F I N A N C I A L R I SKSOUT H EAST E R N SP E CI A LTY, I NC. (SSI), is a not-for-profit corpo? ration formed byphysicians in the College of Medicine at Southeast? ern University. SSI, with more than 600physicians, provides the medi? cal staff for University Hospital. In addition, SSI staffs andadministers a network of 25 ambulatory care clinics and centers at ten locations within 50 miles ofthe hospital. In 2009, SSI generated more than $500 million in revenues from about 40,000 inpatientstays and 750,000 out? patient visits.More than 70 percent of SSI's revenues come from inpatient stays, but this percentage has beendeclining, and by 2014, more than half of SSI's revenues are expected to stem from outpatientservices. As im? provements are made in technology and third-party payers continue to pressureproviders to cut costs, more and more inpatient services will be converted to outpatient and homecare. For example, in i999, 80 per? cent of SSI's ophthalmological surgeries took place inUniversity Hospi? tal, while in 2009, 80 percent were conducted in outpatient settings.Although SSI has traditionally provided only specialty services, in 2004 it instituted a "personalphysician services" program, in which patients can receive both primary and specialty care fromCollege of Medicine physicians. This was the first step in SSI's drive to develop an integrateddelivery system, which offers a full range of patient services. Now that the system is in place,SSI is contracting with managed care plans to provide virtually all physician services requiredlocally by plan members. Furthermore, SSI is examining the feasibility of contractingIOI? HAP, 2010. Reproduction without permission is prohibited.;102 Cases in Healthcare Finance;directly with employers and hence bypassing managed care plans, but no decision has yet been made.Indeed, state insurance industry repre? sentatives expressed opposition to the idea when SSI firstannounced the possibility of direct contracting. The insurance industry position is that directcontracting with employers to provide a complete health? care benefit package is an insurancefunction, which can be under? taken only by licensed insurance plans.As part of its continuing education program, SSI holds monthly"nonclinical grand rounds" for its physicians, in which various staff members and outsidespecialists conduct seminars on nonclinical top? ics of interest. As part of this series, ChrisJohnson, SSI's chief finan? cial officer, has been invited to conduct two sessions on the financialrisk inherent in integrated delivery systems. His main concern is that physicians, although verysophisticated in clinical matters, have a very limited understanding of basic financial riskconcepts and will not ap? preciate the financial issues involved in integrated delivery systemswithout first gaining an understanding of basic financial risk concepts. Thus, he plans to devotethe entire first session to basic concepts.In preparation for the seminar, Chris developed the return distri? butions for the five investmentsshown in Exhibit 13.i. To create the table, he first hypothesized that five economic states arepossible for the coming year, ranging from poor to excellent. Next, he estimated the one-yearreturns on each investment under each state. The five investments are (1) T-bills, (2) real assetinvestment Project A, (3) real asset investment Project B, (4) an index fund designed to proxy thereturns on the Standard & Poor (S&P) 500 stock index, and (5) an equity investment in SSI itself.T-bills are short-term (one year or less maturity) U.S. Treasury debt securities, Project A is aproposed sports medicine clinic, and Project B is a Medicaid-funded project for pro? viding familyhealth services to an underserved area. Note that Chris developed the returns for Projects A and Band for SSI as a whole by assessing the impact of each economic state on healthcare utilization andreimbursement patterns.In addition to the returns on these alternative investments, Chris developed the followingquestions to use as the structure for his presen? tation. See if you can answer them.;i. Is the return on the one-year T-bill risk free?2. Calculate the expected rate of return on each of the five investment alternatives listed inExhibit 13.i. Based;Case 13: Southeastern Specialty, Inc. 103;solely on expected returns, which of the potential investments appears best?3? Now calculate the standard deviations and coefficients of variation of returns for the fivealternatives. (Hint:Coefficient of variation of return is defined as the stan- dard deviation divided by the expectedrate of return.It is a standardized measure of risk that assesses risk per unit of return.)a. What type of risk do these statistics measure?b. Is the standard deviation or the coefficient of varia- tion the better measure?c. How do the five investment alternatives compare when risk is considered?4? Suppose SSI forms a two-asset portfolio by investing in both Projects A and B.a. To begin, assume that the required investment is the same for both projects- say, $5 millioneach.(1) What will be the portfolio's expected rate of return, standard deviation, and coefficient ofvariation?(2) How do these values compare with the corre- sponding values for the individual projects?(3) What characteristic of the two return distribu- tions makes risk reduction possible?b. What do you think will happen to the portfolio's expected rate of return and standarddeviation if the portfolio contained 75 percent of Project A? If it contained 75 percent of ProjectB?5? Now consider a portfolio that consists of investments in Project A and the S&P 500 Fund.a. First, consider a portfolio containing equal invest- ment in the two assets. Will thisportfolio have the same risk-reducing effect as the Project A/Project B portfolio considered inQuestion 4? Explain.b. What are the expected returns and standard devia- tions for a portfolio mix of o percentProject A, 10 percent Project A, 20 percent Project A, and soon-up to 100 percent Project A?6. Suppose an individual investor starts with a portfolio that consists of one randomly selectedstock.;104 Cases in Healthcare Finance;a. What will happen to the portfolio's risk if more and more randomly selected stocks are added?b. What are the implications for investors? Do port? folio effects have an impact on the wayinvestors should think about the riskiness of individual securities?c. Explain the differences between stand-alone risk, diversifiable risk, and portfolio risk.d. Suppose that you choose to hold a single stock investment in isolation. Should you expect tobe compensated for all of the risk that you assume?7. Now change Exhibit 13.1 by crossing out the state of the economy and probability columns andreplacing them with Year 1, Year 2, Year 3, Year 4, and Year 5. In other words, assume that thedistributions represent historical returns earned on each asset in each of the last five years.a. Plot four lines on a scatter diagram (regression lines) that show the returns on the S&P 500Fund (the market) on the x-axis and (1) T-bill returns,(2) Project A returns, (3) Project B returns, and(4) SSI returns on the y-axis.(1) What are these lines called?(2) Estimate the slope coefficient of each line. What is the slope coefficient called, and what isits significance? (If you have a calculator with statistical functions or are using a spread?sheet, use linear regression to find the slope coefficients.)(3) What is the significance of the distance between the plot points and the regression line- thatis, the errors?b. Plot two lines on a different scatter diagram that show the returns on SSI (the company) on thex-axis and (1) Project A returns and (2) Project Breturns on the y-axis.(1) What are these lines called?(2) Estimate the slope coefficient of each line. What is the slope coefficient called, and what;Case i3: Southeastern Specialty, Inc. 105;is its significance? (If you have a calculator with statistical functions or are using a spread?sheet, use linear regression to find the slope coefficients.)c. If you were an individual investor who could buyany of the assets in Exhibit 13.1, which one(s) would you buy? Why? (Hint: To help answer thisquestion, construct a Security Market Line graph and plot the expected returns on each asset on thegraph. Also, note that SSI is actually a not-for-profit corporation, so it is impossible to buy anequity interest in the company. For this question, assume that SSI is an investor-owned company.)d. Now assume that you are the chief executive officer of SSI and you have to decide whetherto invest in Project A, Project B, or both. Which project(s) would you choose if you could acceptboth? Ifyou could only accept one of the two, which would you choose? Why? (Hint: To help answerthis question, construct a "Corporate Market Line" graph, which plots corporate betas rather thanmarket betas on the x-axis, and plot the expected returns for each project on the graph.)8. a. What is the market risk of each project (A andB) relative to the aggregate market risk of SSI? (For this question, assume that SSI is aninvestor? owned company.) No additional calculations are necessary.b. What is the corporate risk of each project (A andB) relative to the aggregate corporate risk of SSI? No additional calculations are necessary.9. a. What is the efficient markets hypothesis (EMH)?b. What impact does this theory have on decisions concerning investments in securities?c. Is the EMH applicable to real asset investments, such as the decision of SSI to invest inProject A or Project B?d. What impact does the EMH have on corporate financing decisions?;EXHIBIT 13.1Southeastern Specialty,Inc.: Estimated One-Year Return Distributions on Five Investments106 Cases in Healthcare FinanceEstimated Return on InvestmentState of 1-Year S&P 500 Equity in thethethethe EconomyEconomyEconomyEconomy PPPProbabilitrobabilitrobabilitrobabilit yyyy TTTT-Bill-Bill-Bill-Bill ProjectProjectProjectProject AAAA ProjectProjectProjectProject BBBB FundFundFundFund SS/SS/SS/SS/;Poor 0.10 7.0% -8.0% 18.0% -15.0% 0.0%Below average 0.20 7.0 2.0 23.0 0.0 5.0Average 0.40 7.0 14.0 7.0 15.0 10.0Above average 0.20 7.0 25.0 -3.0 30.0 15.0Excellent 0.10 7.0 33.0 2.0 45.0 20.0;Note: These return distributions are fictitious and not meant to describe actual market conditionsat the time you work this case.20.0

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