FACULTY PRACTICE, INC.;FINANCIAL RISK;FACULTY PRACTICE, INC., (FPI) is a not-for-profit corporation formed by physicians in the College of iMedicine at Southeastern University. FPI, with over 600 physicians, provides the medical staff for University Hospital. In addition, FPI staffs and administers a network of 25 ambu?latory care clinics and centers at ten locations within 50 miles of the hospital. In 2005, FPI generated over $500 million in revenues from about 40,000 inpatient stays and 750,000 outpatient visits.;Over 70 percent of FPI's revenues currently come from inpatient stays, but this percentage has been declining, and by 2010, over half of FPI's revenues are expected to stem from outpatient services. As im?provements are made in technology and third-party payers continue to pressure providers to cut costs, more and more inpatient services will be converted to outpatient and home care. For example, in 1995,8? percent of FPI's ophthalmological surgeries took place in University Hospital, while in 2005, 80 percent were conducted in outpatient settings.;Although FPI has traditionally provided only specialty services, in 2000 it instituted a "personal physician services" program, in which patients can receive both primary and specialty care from College of Medicine physicians. This was the first step in FPI's drive to develop an integrated delivery system, which offers a full range of patient services. Now that the system is in place, FPI is contracting with managed care plans to provide virtually all physician services required locally by plan members. Furthermore, FPI is examining the feasibility of contracting directly with employers, and hence bypassing managed care plans, but;95;96 Cases in Healthcare Finance;no decision has yet been made. Indeed, state insurance industry repre-sentatives expressed opposition to the idea when FPI first announced the possibility of direct contracting. The insurance industry position is that direct contracting with employers to provide a complete healthcare benefit package is an insurance function, which can be undertaken only by licensed insurance plans.;As part of its continuing education program, FPI holds monthly "nonclinical grand rounds" for its physicians, in which various staff members and outside specialists conduct seminars on nonclinical top-ics of interest. As part of this series, Chris Johnson, FPIs chief financial officer, has been invited to conduct two sessions on the financial risk inherent in integrated delivery systems. His main concern is that physi?cians, although very sophisticated in clinical matters, have a very limited understanding of basic financial risk concepts and will not appreciate the financial issues involved in integrated delivery systems without first gaining an understanding of basic financial risk concepts. Thus, he plans to devote the entire first session to basic concepts.;In preparation for the seminar, Chris developed the return distribu-tions for the five investments shown in Table 13.1. lb create the table, he first hypothesized that there could be five possible economic states for the coming year, ranging from poor to excellent. Next, he estimated the one-year returns on each investment under each state. The five invest?ments are (1) T-bills, (2) real asset investment Project A, (3) real asset investment Project B, (4) an index fund designed to proxy the returns on the Standard & Poor (S&P) 500 stock index, and (5) an equity invest?ment in FPI itself. T-bills are short-term (one-year or less maturity) U.S. Treasury debt securities, Project A is a proposed sports medicine clinic, and Project B is a Medicaid-funded project for providing family health services to an underserved area. Note that Chris developed the returns for Projects A and B and for FPI as a whole by assessing the impact of each economic state on healthcare utilization and reimbursement patterns.;In addition to the returns on these alternative investments, Chris developed the following questions to use as the structure for his presen?tation. See if you can answer his questions.;1. 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 in Table 13.1. Based;Faculty Practice, Inc. 97;Estimated Return on Investment;State of;1-Year S&P 500 Equity in;the Economy Probability '-Bill Project A Project B Fund FPl;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 5.0;Average 0.40 7.0 14.0 7.0 15.0 10.0?;Above average 0.20 7.0 25.0 -3.0 30.0 15.0;Excellent 0.10 7.0 33.0 2.0 45.0 20.0;TABLE 13.1 Faculty Practice, Inc. Estimated One-Year Return Distributions on Five Investments;solely on expected returns, which of the potential investments appears best?;Now calculate the standard deviations and coefficients of variation of returns for the five alternatives. (Hint: Coefficient of variation of return is defined as the stan?dard deviation divided by the expected rate 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?;Suppose FPl 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 million each.;(1) What would be the portfolio's expected rate of return, standard deviation, and coefficient of variation?;(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 would happen to the portfolio's expected rate of return and standard deviation if;98 Cases in Healthcare Finance;the portfolio contained 75 percent of Project A? If it contained 75 percent of Project B?;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. Would this portfolio have the same risk-reducing effect as the Project A/Proj?ect B portfolio considered in question 4? Explain.;b. What are the expected returns and standard devia?tions for a portfolio mix of o percent Project A, 10 percent Project A, 20 percent Project A, and so on ?up to 100 percent Project A?;6. Suppose an individual investor starts with a portfolio that consists of one randomly selected stock.;a. What would happen to the portfolio's risk if more and more randomly selected stocks were added?;b. What are the implications for investors? Do port?folio effects have an impact on the way investors should think about the riskiness of individual secu?rities?;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 to be compensated for all of the risk that you assume?;7. Now change Table 13.1 by crossing out the state of the economy and probability columns and replacing them with Year 1, Year 2, Year 3, Year 4, and Year 5. In other words, assume that the distributions represent histori?cal 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 500 Fund (the market) on the x-axis and (1) T-bill returns, (2) Project A returns, (3) Project B returns, and (4) FPl 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;Faculty Practice, Inc.;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.) (3) What is the significance of the distance be?tween the plot points and the regression line ? that is, the errors?;b. Plot two lines on a different scatter diagram that show the returns on FPI (the company) on the x-axis and (1) Project A returns and (2) Project B 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 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 buy any of the assets in Table 13.1, which one(s) would you buy? Why? (Hint: To help answer this ques?tion, construct a Security Market Line graph and plot the returns on each asset on the graph. Also, note that FPI is actually a not-for-profit corpora?tion, so it would be impossible to buy an equity interest in the company. For this question, assume that FPI were an investor-owned company.);d. Now assume that you are the chief executive officer of FPI and you have to decide whether to invest in Project A, Project B, or both. Which project(s) would you choose if you could accept both? If you could only accept one of the two, which would you choose? Why? (Hint: To help answer this question, construct a "Corporate Market Line" graph, which plots corporate betas rather than market betas on the x-axis, and plot the returns for each project on the graph.);a. What is the market risk of each project (A and B) relative to the aggregate market risk of FPI? (For;Cases in Healthcare Finance;this question, assume that FPI were an investor-owned company.) b. What is the corporate risk of each project (A and B) relative to the aggregate corporate risk of FPI? 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 FPI to invest in Project A or Project B?;d. What impact does the EMH have on corporate financing decisions?
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