Business Risk and the Tradeoff Theory of Capital Structure: Predicting the Use of Long-Term Debt in the Healthcare Sector.

Abstract

In an effort to understand the appropriate capital structure for healthcare firms, a two-stage approach to predict the use of long-term debt can provide valuable insight into the determinants of leverage. As evidenced by samples that are limited to firms with leverage, the historical predictors of long-term debt can explain over 26% of the variation. However, there is a high prevalence low/non-leveraged firms that truncates the dependent variable and requires adjustments to account for the probability of having leverage. After adjusting for the truncation of the dependent variable, the traditional determinants of debt account for less than 6% of the variation. Business risk (BR) can improve estimates but the importance of using long-term risk to determine capital structure is not self-evident when examining business risk independently (BR in the same, two-part model accounts for just over 9% of the variation in the sample). The benefits of using business risk are best realized when paired with the traditional determinants of debt. At the sector level, the pairing of BR and traditional factors improves prediction substantially (10-229%). Business risk in tandem with other determinants of capital structure does improve predictive power in a two-part model. However, because of the frequency of NFP entities in the Healthcare Sector, an approximation of BR was developed and used in a sample of IO and NFP firms. Within the IO sample, a combined model (BR and traditional determinants) that uses the BR approximation explains over 33% of the variance in long-term debt usage among healthcare providers and service firms. The same BR proxy and model explains 7.2% of the variance among NFP hospitals. The model does slightly better (R2=.132) when the sample is limited to short-term NFP hospitals. The substantially different results among the IO and NFP firms suggest that a) NFP firms are not adequately accounting for risk when determining their long-term debt usage, b) NFP healthcare facilities have a different response to risk relative to their IO counterparts, or c) the benefits of long-term debt financing that accrue to NFP firms are greater than the benefits that accrue to IO firms.