Critique this statement: 1.) The use of debt financing lowers the net income of the firm, and hence debt financing should be used only as a last resort. 2.) Discuss some factors that health services managers must consider when choosing between debt and equity financing. Consider both investor-owned and not-for-profit firms in your answer. 3.) What capital components are typically included when estimating a firms corporate cost of capital? Is the corporate cost of capital the same for all firms? Explain your answer. LECTURE NOTES BELOW: Capital Structure Lesson 12 Lecture Notes COST OF CAPITAL Capital refers to the funds invested in a business. The capital can come from different sources. All capital has a cost. However, it varies from one sources of capital to another, from one company to another, and from one period of time to another. Cost of capital may be defined as the company’s cost of collecting funds. This is equal to the average rate of return that an investor in a company will expect for providing funds. It is the minimum rate of return that the project must earn to keep the value of the company intact. The minimum rate of return is equal to cost of capital. The cost of capital is always expressed in terms of percentage. Proper allowance is made for tax purposes. This is done to get a correct picture of the cost of capital. The concept of cost of capital is a major standard for comparison used in financial decisions. Acceptance or rejection of an investment project depends on the cost that the company has to pay for financing it. Good financial management involves selection of projects which are expected to earn returns higher than the cost of capital. Therefore, it is important for the financial manager to calculate the cost of capital which the company has to pay and compare it with the rate of return which the project is expected to earn. In capital expenditure decisions, financial managers typically accept projects arranged in descending order of rate of return. They stop at the point where the cost of capital equals the rate of return offered by the project. That is, the financial manager finds out the break-even point of the project. Accepting any project below the break-even point will cause financial loss for the company. The cost of capital is a guideline for determining the optimum capital structure of a company. In order to calculate the overall cost of capital, a financial manager should take the following steps: Determine the type of funds to be raised and their share in the capital structure. Determine cost of each type of funds. Calculate combined cost of capital of the company by giving weights to each type of funds in terms of proportion of funds raised to total funds. (Patil, 2013) DEBT FINANCING Debt is borrowing money from an outside source with the promise to return the principal, in addition to an agreed-upon level of interest. Although the term tends to have a negative connotation, startup companies often turn to debt to finance their operations. In fact, even the healthiest of corporate balance sheets will include some level of debt. In finance, debt is also referred to as leverage. The most popular source for debt financing is the bank, but debt can also be issued by a private company or even a friend or family member. Advantages to Debt Financing Maintain ownership: When you borrow from the bank or another lender, you are obligated to make the agreed-upon payments on time, but that is the end of your obligation to the lender. You can choose to run your business however you choose without outside interference. Tax deductions: This is a huge attraction for debt financing. In most cases, the principal and interest payments on a business loan are classified as business expenses, and thus can be deducted from your business income taxes. Drawbacks to Debt Financing Repayment: As mentioned above, your sole obligation to the lender is to make your payments. Unfortunately, even if your business fails, you will still have to make these payments. If you are forced into bankruptcy, your lenders will have claim to repayment before any equity investors. High rates: Even after calculating the discounted interest rate from your tax deductions, as explained above, you may still be faced with a high interest rate. Interest rates will vary with macroeconomic conditions, your history with the banks, your business credit rating, and your personal credit history. Impacts your credit rating: It might seem attractive to keep bringing on debt when your firm needs money, a practice knowing as levering up, but each loan will be noted on your credit rating. The more you borrow, the higher the risk to the lender, and the higher interest rate youll pay. Cash and collateral: Even if you plan to use the loan to invest in an important asset, youll need to make sure your business will be generating sufficient cash flows by the time loan repayment starts. Youll likely be asked to put up collateral on the loan in case you default on your payments. Alternatives to Debt Financing Equity financing: This involves selling shares of your company to interested investors, or putting your own money into the company. Mezzanine financing: Lenders who set up this debt tool offer the business unsecured debt (no collateral is required). The trade-off is a high interest rate, in the 20- 30 percent range. The lender has the right to convert the debt into equity in the company if the company defaults on payments. Despite the high interest rate, mezzanine financing appeals to entrepreneurs because it offers quick liquidity, and even though it can be converted to equity, the issuing bank usually does not want to be an equity holder, meaning theyre not looking to control the company. Hybrid financing: Most likely youll turn to a combination of debt and equity financing to fund your venture. The question then becomes: What is the proper combination? When to Use Debt Financing As mentioned above, the lender will be seeking installment payments on his loan shortly after the money is lent. That means in order to begin making payments you will need cash. Even a thriving business can be short on cash if its money is tied up in equipment, or customers arent paying. When considering debt, ask yourself: Am I using this money to invest in fixed or variable costs? If youre investing in fixed costs, such as a new piece of equipment, then you likely wont see any cash returns from it in the short-term. If you need the money to invest in variable costs such as materials for the product you make or costs associated with each new client, than the debt investment should have associated cash inflow. What are my customers like? Customers who consistently pay on time are critical to cash flow and the ability to repay debt. How quickly will you receive cash from your payers, most of whom are insurance companies? Check with professional associations on statistics such as accounts receivable aging and Days Sales Outstanding (DSO). Where am I in my business lifecycle? In the early stages of a firm, debt financing can be dangerous. You will likely be losing money at first, thus hurting your ability to make payments. Since your net income will be low, the tax advantages of debt will be minimal. As your business grows and matures, debt becomes a stronger option. The tax advantage will be greater, your cash flow will be more predictable, and the risk you face in bankruptcy decreases since you have been operating longer. (Richards, n.d.) LECTURE NOTS BELOW:
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