Posted by teresa on Thursday, April 24, 2008 at 12:50pm.
New England Healthcare (NEH) began its two teaching and research hospitals in 1994. Following the two hospitals merger, “several suburban acutecare hospitals had also elected to join the NEH system, as had a large number of primarycare medical practices in the region” (Light, 2005, p.296). New England Healthcare was considered to have high quality health care services and education (teaching) in the course of breakthrough medical research.
With variable operating margins, New England Healthcare struggled to receive reasonable reimbursements from managedcare organizations, government financed, and thirdparty payers. Along with these market factors came additional margin pressures “… due to increased labor costs, rising unemployment”, shortage of professionals, “and government costcontrol efforts” (Light, 2005, p.298).
A meeting conducted by the Investment Committee of New England Health Care, in January 2003, focused on the target asset allocations of its three longterm investment funds. Which include the LongTerm Pool of endowmentlike funds, the assets of a finalsalary pension plan, and the assets of a cash balance pension plan.
The Investment Committee is responsible for tasks related to funds performance evaluations, formulating each funds target, benchmarks (corporate discount rates), and “… tactical asset allocation portfolios; and selecting and monitoring the various external investment firms that manage a large fraction of each fund’s assets” (Light, 2005, p.296).
Within 2003, “… an Executive Committee of the Investment Committee met monthly to monitor tactical allocations and changing market valuations” (Light, 2005, p.298). According to Investopedia (2008), “This strategy allows portfolio managers to create extra value by taking advantage of certain situations in the marketplace. It is a moderately active strategy since managers return to the portfolio's original strategic asset mix when desired shortterm profits are achieved” (p.1). Finding the proper balance in terms of asset allocation planning is an important decision.
“All the funds, except for the LongTerm Pool, were fixed income funds. The LongTerm Pool was a diversified capital appreciation fund that invested in equities, private equity, alternative assets, and certain fixed income investments” (Light, 2005, p.297). See Appendix A; for information on longterm pooled investments.
In determining New England Healthcare LongTerm Pool investment, an important coefficient known as Beta needs to be determined. New England Healthcare’s beta is the company’s risk compared to the risk of the company’s overall policy benchmarks. Ross (2004) states that beta can be calculated in six steps, see Appendix B and C, for information on calculating Beta. The beta is the sum of the covariance divided by the sum of the squared deviations of the market; so Figure 1; shows Beta for the NEH LongTerm Pool and figure 2; shows Beta for the NEH Pension Funds.
Figure 1; Beta for NEH LongTerm Pool
SHAPE \* MERGEFORMAT
Figure 2; Beta for the NEH Pension Fund
SHAPE \* MERGEFORMAT
New England Healthcare’s LongTerm Pool has a beta of 0.78, so therefore it is said to be <1 times more risky than the overall market. Also, the NEH’s Pension Fund has a beta of 0.82, so it is said to be <1 times more risky than the overall market. The overall financial risk was reduced in terms of variability of returns due in part to portfolio diversification. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows.
Ross (2004) states that 8.4% is a good estimate of the market’s risk premium (p.285). In determining the riskfree rate, “... in practice most professionals use shortdated US Treasury Bills” (Wikipedia, 2008, p.1), due to the likely hood of these governments defaulting being extremely low. In the case of New England Healthcare, Ross (2004) “argues that the place to start looking for the risk premium in the future isthe averaage risk premium in the past” (p.258). The average 5yr. Historical return for the LongTerm Pool is 5.7%, see Appendix A for data. “The average riskfree rate over the 1926 – 2002, was 3.8%” (Ross, 2004, p.258). Figure 3 shows the expected return on the market.
Figure 3; calculating the expected return on the market,
SHAPE \* MERGEFORMAT
The riskfree rate was determined by estimating the current yield on a Constant Maturity OneYear U.S. Treasury Bill, year 2002 (Light, 2005, p.309). Figure 4 shows the calculations for computing the cost of equity capital. Light (2005) states that, “Standard & Poor’s rated NEH’s debt at AA“(p. 299). Therefore at an AA rating, cost of debt would be 5.25% over an average duration of 14 years. See Appendix D for yield information.
Figure 4; Calculating Cost of Equity Capital (LongTerm Pool)
SHAPE \* MERGEFORMAT
From the Weighted Average Cost of Capital, the pretax cost of debt is 5.25%, implying an aftertax cost of 3.41% = [.0525(1.35)]. Therefore the weighted average cost of capital for NEH’s LongTerm Pool is 2.96% respectively, implying New England Healthcare pays 2.96% for every dollar the company borrows. The WACC for NEH’s Pension Plans appears slightly higher, at 6.38%. See appendix E and F for calculations leading to the weighted average cost of capital.
By using the Capital Asset Pricing Model (CAPM), implies that the expected return on the security is positively (linearly) related to its beta. Figure 5 shows the calculations needed to determine the expected return on a security using NEH’s allocations. The expected return on the LongTerm Pool can be calculated by taking the riskfree rate (1.32%) adding the LongTerm Pools beta (0.78), then multiplying by the difference between expected return on market and riskfree rate (3.22%).
Figure 5; Rate of return on security
SHAPE \* MERGEFORMAT
So, by investing in NEH’s LongTerm Pool, the company should get at least 3.83% return from the investment.
The investment committee at NEH has adopted a similar approach to its asset allocations, and has chosen similar investment policies for the differing pools of funds. However, upon examination of the different liability structures of these funds, their relationship to each other, and the importance of these funds to New England Healthcare's operations, the investment committee is considering setting a different asset allocation policy for each. Due in part to, different securities are expected to generate different returns. In my opinion, according to the information and calculations that have been provided, NEH should definitely set different asset allocations relative to not only themselves but to to each other.
Appendix A
NEH’s Pooled Investment Funds
as of December 31, 2002
Money Market Funds
ShortTerm Funds
Intermed. Funds
LongTerm Pool
Total Assets at Market Value
$195,894,000
$380,232,000
$414,619,000
1,494,921,000
% of all funds
7.9%
15.4%
16.8%
60.7%
Purpose
1)Capital preserv. 2) Liquidity 3) Income
1) Capital preserv. 2) Income 3) Liquidity
1) Income 2) Capital preserv. 3) Capital apprec. 4) Liquidity
1) Capital apprec. 2) Incomerealized gains 3) Capital preserv. 4) Liquidity
Securities held
Highquality domestic CDs; commercial paper; corp. debt
Domestic, gov., and corp. debt; mortgages
Global bonds incl. highyield and emerging market debt; ave. quality A1/A+
Global equities incl. private equity and alt. investments; longerduration global bonds
Maturity of securities held
Less than 1 year; ave. 90 days
Ave. maturity < 5yrs; ave. duration 2.3 yrs.
Ave. duration 4 years
n.a.
Volatility/inv. Horizon
Very low / very short
Low / 23 years
Moderate / 4+ years
High / 10+ years
Management costs
19 b.p.
14 b.p.
26 b.p.
58 b.p.
Policy benchmarks
iMoneyNet MF Average
Lehman Gov't/Corp. 15 year AAA
Lehman Aggregate
50% Russell 3000 20% MSCI ACWI Free exU.S., 15% Lehman U.S. Aggregate, 15% Tbill + 250 bps
Transaction restrictions
Daily
1st of mon. only; withdrawal 15 days notice
1st of mon. only; 1yr commitment; withdrawal 90 days notice.
1st of mon. only; generally, 3yr commitment; withdrawal 6mon. notice and semiannually only
5yr. Historical returns
2.0% to 6.5% ave. 4.6%
2.0% to 13.3% ave. 7.3%
0.8% to 12.4% ave. 6.3%
7.3% to 31.8% ave. 5.7%
Historical target return
5.0%
6.0%
7.0%
10.0%
(Light, 2005, p.302)
Appendix B
Calculating Beta
LongTerm Pool
Period Ending December 31,2002
Year
Rate of Return
Deviation
Rate of Return Market*
Deviation of Market
Covariance
Deviation²
1
.0768
.0934
.1194
.0919
.0056
.0084
3
.0168
.0334
.0785
.0510
.0017
.0026
5
.0570
.0404
.0160
.0435
.0018
.0019
8
.1030
.0864
.0720
.0995
.0086
.0099
Ave
.0166

.0275
Sum
.0177
.0228
* Weighted average of market indices; 50% Russell 3000, 20% MSCI ACWI Free exU.S., 15% Lehman U.S. Aggregate, 15% one year TBill bps. Information provided by (Light, 2005, p.306).
Appendix C
Calculating Beta
Pension Funds
Period Ending December 31, 2002
Year
Rate of Return
Deviation
Rate of Return Market*
Deviation of Market
Covariance
Deviation²
1
.0547
.0733
.0918
.0770
.0056
.0059
3
.0004
.0182
.0536
.0388
.0007
.0015
5
.0497
.0311
.0258
.0406
.0013
.0016
8
.0790
.0604
.0604
.0752
.0045
.0057
Ave
.0186

.0148
Sum
.0121
.0147
Weighted average of market indices; 45% Russell 3000, 15% MSCI ACWI Free exU.S., 25% Lehman U.S. Aggregate, 15% one year TBill + 250bps. Information provided by (Light, 2005, p.309).
Appendix D
Bond Yields by Credit Rating
As of December 31, 2002
Credit Rating
Merrill Lynch Municipal BondsHospital Index
Average Duration (Years)
Merrill Lynch U.S. Corp. Bonds Index15+ Year Maturity
Average Duration (Years)
AAA
.0547
.0733
.0918
.0770
AA
.0004
.0182
.0536
.0388
A
.0497
.0311
.0258
.0406
BBB
.0790
.0604
.0604
.0752
(Light, 2005, p. 305)
Appendix E
Weighted Average Cost of Capital (WACC)
LongTerm Pool Fund
Debttovalue ratio D
.733
Equitytovalue ratio E
.266
Cost of Debt b
.0525
Cost of Equity y
.0280
Corporate tax rate t(c)
.35
The WACC will then be
= .733 * .0280 + .266 * .0525 * .65
= .020524 + .00907725
= .02960125 or ~ 2.96%
By using the Target Asset Allocations for NEH LongTerm Pool provide by Light, 2005, p.305), the WACC will then calculate to
= .85/(.15 + .85) * .0280 + .15/(.15 + .85) * .0525 * (1.35)
= .85 * .0280 + .15 * .0525 * .65
= .02891875 or ~ 2.89%
Appendix F
Weighted Average Cost of Capital (WACC)
Pension Plans
Debttovalue ratio D
.201
Equitytovalue ratio E
.799
Cost of Debt b
.0525
Cost of Equity y
.0713
Corporate tax rate t(c)
.35
By using the Target Asset Allocations for NEH Pension Plans provide by Light, 2005, p.308), the WACC will calculate to 6.38%.
R(equity) = .0132 + 0.82 (.084  .0132)
= .071256 or ~ 7.13%
= .799 * .0713 + .201 * .0525 * (1  .35)
= .0569687 + .0068591
= .063828 or 6.38%
References
Appendices and Figures
Appendix A: NEH’s Pooled Investment Funds as of December 31, 2002
Appendix B: Calculating Beta LongTerm Pool Period Ending December 31,2002
Appendix C: Calculating Beta Pension Funds Period Ending December 31, 2002
Appendix D: Bond Yields by Credit Rating as of December 31, 2002
Appendix E: Weighted Average Cost of Capital LongTerm Pool Fund
Appendix F: Weighted Average Cost of Capital Pension Plans
Figure 1: Beta for NEH LongTerm Pool
Figure 2: Beta for NEH Pension Funds
Figure 3; calculating the expected return on the market
Figure 4; Calculating Cost of Equity Capital (LongTerm Pool)
Figure 5; Rate of return on security
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