New England Healthcare (NEH) began its two teaching and research hospitals in 1994. Following the two hospitals merger, “several suburban acute-care hospitals had also elected to join the NEH system, as had a large number of primary-care 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 break-through medical research.
With variable operating margins, New England Healthcare struggled to receive reasonable reimbursements from managed-care organizations, government financed, and third-party payers. Along with these market factors came additional margin pressures “… due to increased labor costs, rising unemployment”, shortage of professionals, “and government cost-control 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 long-term investment funds. Which include the Long-Term Pool of endowment-like funds, the assets of a final-salary 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 short-term 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 Long-Term Pool, were fixed income funds. The Long-Term 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 long-term pooled investments.
In determining New England Healthcare Long-Term 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 Long-Term Pool and figure 2; shows Beta for the NEH Pension Funds.
Figure 1; Beta for NEH Long-Term Pool
SHAPE \* MERGEFORMAT
Figure 2; Beta for the NEH Pension Fund
SHAPE \* MERGEFORMAT
New England Healthcare’s Long-Term 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 risk-free rate, “... in practice most professionals use short-dated 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 Long-Term Pool is 5.7%, see Appendix A for data. “The average risk-free 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 risk-free rate was determined by estimating the current yield on a Constant Maturity One-Year 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 (Long-Term Pool)
SHAPE \* MERGEFORMAT
From the Weighted Average Cost of Capital, the pretax cost of debt is 5.25%, implying an after-tax cost of 3.41% = [.0525(1-.35)]. Therefore the weighted average cost of capital for NEH’s Long-Term 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 Long-Term Pool can be calculated by taking the risk-free rate (1.32%) adding the Long-Term Pools beta (0.78), then multiplying by the difference between expected return on market and risk-free rate (3.22%).
Figure 5; Rate of return on security
SHAPE \* MERGEFORMAT
So, by investing in NEH’s Long-Term 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
Short-Term Funds
Intermed. Funds
Long-Term 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) Income-realized gains 3) Capital preserv. 4) Liquidity
Securities held
High-quality domestic CDs; commercial paper; corp. debt
Domestic, gov., and corp. debt; mortgages
Global bonds incl. high-yield and emerging market debt; ave. quality A1/A+
Global equities incl. private equity and alt. investments; longer-duration 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 / 2-3 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. 1-5 year AAA
Lehman Aggregate
50% Russell 3000 20% MSCI ACWI Free ex-U.S., 15% Lehman U.S. Aggregate, 15% T-bill + 250 bps
����������Transaction restrictions
Daily
1st of mon. only; withdrawal 15 days notice
1st of mon. only; 1-yr commitment; withdrawal 90 days notice.
1st of mon. only; generally, 3yr commitment; withdrawal 6-mon. notice and semiannually only
����������5-yr. 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
Long-Term 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 ex-U.S., 15% Lehman U.S. Aggregate, 15% one year T-Bill 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 ex-U.S., 25% Lehman U.S. Aggregate, 15% one year T-Bill + 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 Bonds-Hospital Index
Average Duration (Years)
Merrill Lynch U.S. Corp. Bonds Index-15+ 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)
Long-Term Pool Fund
Debt-to-value ratio D
.733
Equity-to-value 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 Long-Term 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
Debt-to-value ratio D
.201
Equity-to-value 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 Long-Term 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 Long-Term Pool Fund
Appendix F: Weighted Average Cost of Capital Pension Plans
Figure 1: Beta for NEH Long-Term Pool
Figure 2: Beta for NEH Pension Funds
Figure 3; calculating the expected return on the market
Figure 4; Calculating Cost of Equity Capital (Long-Term Pool)
Figure 5; Rate of return on security
Investment Larios PAGE 1
Based on the information provided, here is a step-by-step breakdown of the key points:
1. New England Healthcare (NEH) established two teaching and research hospitals in 1994, followed by the merger of several suburban acute-care hospitals and primary-care medical practices in the region.
2. NEH faced challenges in receiving reasonable reimbursements from managed-care organizations, government financing, and third-party payers, leading to variable operating margins.
3. The Investment Committee of NEH met in January 2003 to discuss the target asset allocations of its three long-term investment funds: the Long-Term Pool, the assets of a final-salary pension plan, and the assets of a cash balance pension plan.
4. The Investment Committee's responsibilities include performance evaluations, formulating target benchmarks, tactical asset allocation portfolios, and selecting and monitoring external investment firms.
5. The Executive Committee of the Investment Committee met monthly in 2003 to monitor tactical allocations and changing market valuations.
6. Tactical asset allocation involves taking advantage of market situations to create extra value, returning to the original strategic asset mix when desired short-term profits are achieved.
7. The Long-Term Pool of investments included a diversified capital appreciation fund that invested in equities, private equity, alternative assets, and fixed income.
8. Beta, a coefficient that measures a company's risk compared to the risk of the overall market, needed to be determined for NEH's Long-Term Pool and Pension Funds.
9. NEH's Long-Term Pool had a beta of 0.78, indicating it was less risky than the overall market, while the Pension Funds had a beta of 0.82.
10. The weighted average cost of capital (WACC) for NEH's Long-Term Pool was 2.96%, implying a cost of 2.96% for every dollar borrowed.
11. The WACC for NEH's Pension Plans was slightly higher at 6.38%.
12. The expected return on NEH's Long-Term Pool investment was calculated to be at least 3.83%.
13. The investment committee at NEH was considering setting different asset allocation policies for each fund due to their different liability structures and relationships.
14. NEH's Long-Term Pool fund had a target return of 10%.
Please note that this breakdown is based on the information provided and may not include all relevant details.
The passage provided discusses New England Healthcare (NEH) and its investment strategy for its long-term investment funds. NEH is a healthcare organization that operates teaching and research hospitals, suburban acute-care hospitals, and primary-care medical practices. However, it faces challenges in receiving reimbursements from managed-care organizations and other payers, along with increased labor costs and government cost-control efforts.
The Investment Committee of NEH is responsible for tasks related to the performance evaluation, target allocation, and monitoring of external investment firms for its three long-term investment funds - the Long-Term Pool, the assets of a final-salary pension plan, and the assets of a cash balance pension plan. The committee meets monthly to monitor tactical allocations and changing market valuations.
To determine the risk and expected returns of the Long-Term Pool, an important coefficient known as Beta needs to be calculated. Beta measures the company's risk compared to the overall market risk. The passage provides the steps to calculate Beta using historical rate of returns and market deviations.
The Long-Term Pool is a diversified capital appreciation fund that includes investments in equities, private equity, alternative assets, and certain fixed income investments. The beta for the Long-Term Pool is 0.78, indicating it is less risky than the overall market. The passage also provides Beta calculations for the NEH Pension Funds.
To determine the expected return on the market and the cost of equity capital, the passage provides information on the risk-free rate and the market's risk premium. It suggests using short-dated US Treasury Bills as a proxy for the risk-free rate and states that the average risk premium in the past can be used as an estimate for the future. The passage includes calculations for the cost of equity capital and the expected return on the security based on NEH's asset allocations.
Based on the calculations provided, NEH's Long-Term Pool is expected to generate a return of at least 3.83%. The passage also discusses the need for different asset allocations for each fund based on their liability structures and the importance of considering different securities and their expected returns.
The appendices provided in the passage include additional information on NEH's investment funds, bond yields by credit rating, and calculations for the weighted average cost of capital (WACC) for the Long-Term Pool and Pension Plans.
Overall, the passage emphasizes the importance of proper asset allocation planning and risk assessment in investment strategies for healthcare organizations like NEH.