Communicating up the Financial Ladder: Medical Finance 101

1. Communicating up the Financial Ladder: Medical Finance 101 Marc J. Kahn, MD MBA (to be) Professor of Medicine Sr. Associate Dean Tulane University School of Medicine

2. Topics • Value of Money • Stocks and Bonds • Risk and Return • Net Present Value

3. Questions • Would you rather have $1,000,000 now or $250,000 each year for the next 4 years? • What is $250,000 a year for 4 years worth today?

4. Time Value of Money • Most basic concept of finance • Money is worth more today than in the future. • Opportunity costs • Investment alternatives

5. Definitions • Interest—money paid for use of your money • Future value—amount to which an investment grows after earning interest • Present value—amount of money you start with

6. Interest Simple—interest earned on initial investment Example: You invest $100 at 6% annual interest. =$100 (1.06) = $106 after one year Compound—interest earned on interest Example: You invest $100 at 6% interest compounded monthly. =$100 (1 + .06/12)12 = $106.17 If compounded daily = $100(1 + .06/365)365 = $106.18

7. Compound Interest Payments • APR = Annual Percentage Rate (most common) • EAR = Effective Annual Rate Example: You have a credit card with an APR of 18%. What is the “real” interest rate annually? APR = monthly rate x 12 Monthly rate = 18/12 = 1.5% EAR = (1 + 1.5%)12 – 1 = 19.56%

8. Why Compounding Matters • Grains of wheat on a chessboard • One grain in square one, double each successive square • Total wheat is more than that in the entire world!! = 1.92 x 10109

9. Future/Present Value FV = PV (1 + r)t

10. Original Questions • Would you rather have $1,000,000 now or $250,000 each year for 4 years? Obviously, money is worth more now! • What is $250,000 a year for 4 years worth today? Assuming 5% interest rate per year =$886,488 Looking at this another way, you would need $282,012 per year for 4 years to have the same amount of money as $1,000,000 now!

11. What is a stock? • Common Stock—Ownership (Equity) in a company • Preferred Stock—preference over dividends but no voting rights • Dividends—cash distributions to shareholders • Market Value—current stock price • Short sale—borrowing stock, selling the borrowed stock and paying it back later hopefully at a lower price

12. What is Stock Worth • Present Value of all future cash flows OR • Present value of all future dividend payments discounted to proper rate of return • Even for a stock that does not pay dividends! • Rate of return is same for all stocks of equal risk

13. What is a Bond? • Bond--an IOU—obligates issuer to make payments to bondholder • Maturity—date that bond principle is to be repaid • Face Value—payment at maturity • Coupon rate—annual interest rate paid as % of face value

14. Bond Example 10 year $10,000 Treasury Note with 6% coupon rate Maturity in 10 years Face value is $10,000 Coupon payments are 6% of $10,000 = $300 payment every 6 months Value = present value of coupon payments + present value of face value

15. Bond Definitions • Discount Bond (zero coupon)—promises single payment at maturity. Sold at discount to face value—all T-bills • US Government Bonds—T-bills < 1 yr • T-notes 1-10 yrs • T-bonds 10-30 yrs

16. Risk • Higher rates of return for HIGHER RISK • Rewarded for RISK • Treasuries are considered risk free • Extra payment is “risk premium” • Historically treasuries have paid 3%, S & P has averaged 5.7% so historic market return is 8.7% • Remember importance of standard deviation and variance!

17. Conundrum • You invest $100 and loose half the first year • Next year gain the $50 back • So, average rate of return = (-50% + 100%)/2 = 25% • How can this be?

18. Geometric Mean [Π (1+rt)]1/t – 1

19. Previous Example Geometric mean: = [(1 + -0.5)(1 + 1)]1/2 – 1 = (0.5)(2)1/2 -1 = 11/2 – 1 = 1 – 1 = 0

20. Points • Diversification reduces risk • Spreads risk across many investments • Lowers variance of portfolio

22. Questions • How much is an MD degree worth over a physicians lifetime? • At what cost of medical school attendance is an MD no longer financially advantageous?

23. Net Present Value • Financial tool • Takes into account costs/revenues at various points of time • Corrects for opportunity costs

24. Equation NPV = C0 + SCt/(1 + r)t

25. Opportunity Cost (r) • Can be thought of as an interest rate • Considers what could have been done with money if used differently • Also called the “discount rate”

26. Calculating Discount Rate • Capital Asset Pricing Model (CAPM) Expected return = Risk Free Return + b(risk premium) • Risk free return = T-bill rate = 3% • Risk Premium = 5.7% (historical average) • b = 0.7 – 1.2 for health care stocks (measurement of market risk)

27. Model Summary Value of MD = total change in salary– cost of attendance – lost wages Corrected for Discount Rate

28. Present Value PV = FV/(1 + r)t

29. Assumptions • Discount rate = 8.7% • Expected salary after college without medical school = $50,000 per year with 3% annual growth • Residency training is 4 years in duration • Salary of a resident is equivalent to that of a college graduate • Incremental salary increase after completing residency is +$130,000 • 35% tax rate • Physician salary is expected to increase 3% per year for 30 years of practice • Setting NPV = $0 and solving for annual cost of attendance results in the breakeven cost of medical education

30. Results

31. Conclusions • Obtaining an MD has high NPV, even at the highest costs of attendance • Only at a cost of attendance of over $160,000 is the NPV less than zero • In the current economic climate, the discount rate is less than 8.7%; this would make an MD degree MORE valuable • Based on economic considerations, the supply of future physicians ought to be secure

32. Pearls • You want your money NOW • Investing early can compound earnings • Rate of return is related to risk • Variance defines range of risk • Diversification minimizes variance and risk • Getting an MD is a good financial deal

33. Questions?