Financial Resources Ch 8

rating designations

1. BBB or higher are considered investment grade and is suitable for investment for conservative individuals and institutions (relatively low risk) 2. BB or lower is called speculative or junk bonds (high risk) 3. although the rating is subjective, they are based on both qualitative characteristics, such as the quality of a business's management, and quantitative factors, such as a business's financial strength

capital structure theory: trade-off theory (widely accepted)

1. a theory proposing that a business's optimal capital structure balances the costs and benefits associated with debt financing 2. the cost: increase bankruptcy risk; the benefit: increase rates of return 3. in effect, the optimal capital structure is the mix of debt and equity financing that produces the lowest cost of capital for the business 4. the key implication of the trade-off theory is that some debt financing is good because owners can capture the benefits of increased return, but too much debt is bad because the increased risk of bankruptcy outweighs the higher expected returns

short-term debt advantages

1. administrative costs generally are higher for long term debt than for short-term debt 2. less restrictive on future actions 3. generally have lower interest rates, because long term debt pose more risk to lenders

bond call provision

1. allows the issuer to repay the bond early 2. usually occurs when interest rates are down and the issuer has the opportunity to refinance their debt at a lower rate

credit line

1. alternatively, a business may obtain short term financing by establishing a line of credit with a bank 2. a credit line is an agreement that specifies the maximum credit the bank will extend to the borrower over a designated period of time, often a year 3. borrowers typically pay an up-front fee to obtain the line, and interest must be paid on any amounts borrowed 4. furthermore, the line must be fully repaid by the end of the year

credit enhancement (bond insurance)

1. because debt ratings affect the cost of financing significantly, healthcare borrowers (particularly not-for-profits) historically have used credit enhancement (bond insurance) to raise the rating on a bond issue 2. regardless of the inherent credit worthiness of the issuer, bond insurance guarantees that bondholders will receive the promised interest and principal payments 3. insured bonds carry the rating of the insurer (insurance company) rather than the issuer 4. credit enhancement gives the issuer access to a lower interest rate, but not without a cost -insurers charge an upfront fee related to the underlying rating of the issue: the lower the borrower's inherent credit rating, the higher the cost of insurance

important factors managers must consider: reserve borrowing capacity

1. businesses generally maintain a reserve borrowing capacity that preserves their ability to obtain additional debt financing 2. managers want to maintain financial flexibility 3. maintaining the ability to borrow additional funds at reasonable interest rates requires a business to use less debt financing during normal times than other factors may indicate

advantages of equity financing

1. businesses need equity capital because it provides a financing base with no maturity date 2. can use equity for long periods without concern that the capital must be repaid 3. furthermore, dividends aren't guaranteed 4. thus, equity financing does not entail the same mandatory periodic payment to capital suppliers as does debt financing 5. finally, lenders do not make business loans if the business has no equity to share the risk, so equity financing is an important precondition to obtain debt financing

commercial banks short term debt

1. can make long term debt but more frequently makes short term debt 2. they are the primary provider of short term debt financing 3. bank loans to businesses are frequently written as 90 day notes, so the loan must be repaid or renewed at the end of the 90 days

setting interest rates: inflation

1. can potentially decrease the purchasing power of the dollar and lowers the value of investment returns 2. lenders are well aware of the impact of inflation and hence, the greater the expected rate of inflation, the greater the interest rate required to offset the loss of purchasing power 3. in addition, the relevant rate of inflation to a lender is the rate expected in the future, not the rate experienced in the past--the anticipated rate of inflation 4. finally, the inflation rate built into the interest rate on a loan is the average rate expected over the life of the loan

debt contracts

1. debt contracts ("loan agreement" or "bond indenture") spell out the rights and obligations of borrowers and lenders 2. these vary substantially in length depending on the type of debt

optimal structure for any business is the mix of debt and equity

1. financing that produces the lowest CCC

important factors managers must consider: asset structure

1. firms whose assets are suitable as security (collateral) for loans pay lower interest rates on debt financing than do other firms and hence tend to use more debt 2. debt capacity: the amount of debt in a businesses optimal capital structure. A business with excess debt capacity is operating with less than the optimal amount of debt

debt ratings are important both to borrowers and lenders

1. first, the rating is an indicator of the issuer's default risk, so the rating has a direct influence on the interest rate required by lenders -the lower the rating, the greater the risk and hence the higher the interest rate 2. second, most corporate bonds are purchased by institutional investors rather than by individuals, so they're restricted to investment-grade securities -as a result of their higher risk and more restricted market, low-grade bonds typically carry much higher interest rates than do high-grade bonds

Introduction

1. if a business is to operate, it must have assets (land, buildings, and equipment) 2. to acquire these assets, it must raise capital

equity in for-profit businesses

1. in for-profit businesses, equity financing is supplied by the owners of the business, either directly through the purchase of an equity (ownership) interest in the business of indirectly through earnings retention 2. most large for-profit healthcare businesses are organized as corporations, in which case the owners are stockholders who contribute equity to the company buying shares of newly issued stock (the sale of stock from one individual to another that was sold by the company in the past does not create equity financing for the business) 3. equity capital is raised when owners provide start-up or additional capital to the business

owners of for-profit businesses rights: right of control

1. in small businesses, the owners typically are the managers of the business and hence, directly control its operations 2. in large businesses (corporations), the owners (stockholders) elect the firm's directors, who in turn elect the officers who manage the business

important factors managers must consider: lender and rating agency attitudes

1. in the majority of situations, managers discuss the business's financial structure with lenders and rating agencies and give a great deal of weight to their advice 2. in large organizations, managers usually have a target debt rating 3. in small businesses, managers want to restrict debt financing to that readily available from commercial banks 4. in effect, lenders and rating agencies set a limit on the proportion of debt financing that a business can raise at "reasonable" interest rates

bond category: corporate bonds

1. issued by for-profit entity (investor-owned) businesses 2. generally held by financial institutions like mutual funds

bond category: municipal bonds

1. issued by states, counties, and cities, and Not-for-profit healthcare organizations -NFP are able to issue municipal bonds through government sponsored healthcare financing authorities 2. the primary attraction of most municipal bonds is the fact that bond owners (lenders, holders) do not have to pay income taxes on the interest earned 3. because of being tax exempt, the interest rate is usually less than those on corporate bonds 4. the idea is that municipal bond buyers are willing to accept a lower interest rate because they do not have to pay income taxes on the interest received

cost of capital

1. lenders and owners provide capital with the expectation of earning a return on their investments -thus, businesses incur a cost to use debt and equity financing 2. the ultimate goal of the cost of capital estimation process is to estimate a business's corporate cost of capital -this cost, in turn, is used as the required rate of return, or hurdle rate, when evaluating the business's capital investment opportunities -the corporate cost of capital is a weighted average of the capital component costs, that is, the cost of debt and equity 3. after the component costs have been estimated, they are combined to form the corporate cost of capital, with the weights representing the business's target capital structure -minimal acceptance rate of return on new capital investment decision 4. the corporate cost of capital primarily is used to evaluate long term assets

The assumption that an owner's position in a business is riskier than a lender's is based on the following facts

1. lenders have a contractually guaranteed return as specified. in the debt agreement -if borrowers fail to make the promised payments, lenders have recourse against the business 2. lenders can force a business into bankruptcy with the goal of recovering their investment in a court-ordered liquidation 3. owners do not have no contractually guaranteed return -if the business succeeds the returns can be high -in bankruptcy, equity holders typically get nothing back

debt ratings

1. major debt issuers, as well as their specific debt issues, are assigned credit worthiness (quality) ratings that reflect the probability of default 2. the three primary rating agencies: Fitch Ratings, Moody's investors service, and Standard and Poor's (S&P) 3. rate both corporate and municipal debt

debt contracts: restrictive covenants

1. many debt contracts include provisions, called restrictive covenants 2. protects the lender from managerial actions that would be detrimental to lenders' interests

long term debt: bonds

1. many lenders 2. a bond is a long term loan under which a borrower agrees to make payments of interest and principal, on specific dates to the holder of the bond 3. a bond issue generally is offered to the public by the borrowing entity and sold to many different investors 4. terms -lender: holder -borrower: issuer -interest rate: coupon rate 5. large amounts of capital can be raised in a bond issue -to reach a lot of investors bonds generally are sold through brokers rather than directly by the borrowing company 6. generally have maturity of 10-30 years, there can be shorter or longer maturities 7. bonds usually pay only interest over the life of the bond, and the entire amount is returned at maturity 8. most have a fixed interest rate, but some have floating 9. today, most people receive statements from the issuer (or its agent) instead of an engraved certificate

debt financing

1. many types of debt financing are available -home mortgages, personal auto loans, are used by individuals, while other debt is for longer terms 2. when money is borrowed, the borrower (whether a business or an individual) has a contractual obligation to repay the loan, so debt obligations are "fixed by contract" 3. the repayment consists of two parts: -the amount borrowed (principal) -the amount of interest stated on the loan

short-term debt

1. maturity is one year or less 2. generally used to finance temporary needs

Equity in Not-for-profit businesses

1. most not-for-profit services organizations, particularly hospitals, received their initial, start-up equity capital from religious, educational, or governmental entities 2. today, not-for-profit businesses obtain much of their equity capital from retained earnings -in fact, all profits earned by a not-for-profit organization must be retained within the organization -it has no owners to receive dividends 3. in theory, NFP orgs provide (dividends) to the community at large by offering healthcare services to the poor, educational programs, and other charitable endeavors 4. raise equity capital through charitable contributions -individuals and businesses want to contribute to NFP healthcare organizations for a variety of reasons: -concern for the well being of others, the recognition that often accompanies large contributions, and tax deductibility -this source of funding is not available to investor-owned businesses -can be a significant source of equity capital for not-for-profit businesses 5. equity in NFP serves the same purpose as equity in For profit business -provides a permanent financing base and supports the business's ability to use debt financing 6. in NFP organizations, equity financing may be called fund capital or net assets

optimal capital structure implications

1. once a business estimates its optimal capital structure it will take the financing actions necessary to attain that structure 2. then, as the business needs additional capital to finance asset replacement and growth, it will raise capital over time so as to maintain its optimal capital structure 3. thus, future financing decisions will be mostly based (targeted) on the optimal capital structure, so the optimal capital structure often is called the target capital structure -the capital structure that a company strives to achieve and maintain overtime -generally the same as the optimal capital structure

long term debt: term loans

1. one lender 2. a term loan is a long term debt financing that is arranged directly between the borrowing business and the lender 3. the lender provides the capital, and the borrower agrees to pay the stated interest rate over the life of the loan and return the amount borrowed 4. typically, the lender is a financial institution such as a commercial bank, a mutual fund, or an insurance co, but it can also be a wealthy investor 5. most have a maturity of 3-10 years 6. most are paid off in equal installments over the life of the loan -some of the principal is paid with each payment 7. the interest rate -can be fixed or variable (a floating-adjusts to the economy specifically the index rate -basis points: one hundredth of a percentage point --just move it over two places to get the percentage

debt financing: long term debt

1. one year and up 2. long term debt is defined as debt that has a maturity greater than one year 3. long term debt typically is used to finance assets that have a long useful life, such as buildings and equipment 4. the two major types of long term debt used by health services organizations are term loans and bonds

important factors managers must consider: industry averages

1. presumably, managers act rationally, so the capital structures of other firms in the industry, particularly the industry leaders, should provide insights about the optimal structure

owners of for-profit businesses rights: right to have a claim on the residual earnings

1. right to have a claim on the residual earnings of the business 2. residual earnings: the earnings (profits) of a business after all expenses (including interest on debt financing) have been paid 3. they belong to the owners 4. some portion of these earnings may be paid out to owners as dividends (in the case of corporations) or bonuses (in the case of proprietorships or partnerships), while the remainder is retained (reinvested) within the business 5. such retentions are a major source of equity capital in for-profit businesses

debt cost plus risk premium method

1. several methods can be used to establish a business's cost of equity but we will focus on one: debt cost + risk premium method 2. this method operates on the premise that equity investments are riskier than debt investments 3. under this assumption, the cost of equity for any business is the cost of debt + a risk premium 4. studies suggest that the risk premium for use in the debt cost + risk premium method has a range from 3-5 percentage points with an average of 4 points COST of Equity = cost of debt + risk premium 5. typically, small businesses have a higher risk premium 6. NFPs incur a cost of equity that represents the return required on the community's equity investment in the organization 7. risk addition is dependent on the specific business

short-term debt disadvantage

1. the borrower is subject to more risk than in long term debt 2. this increase risk occurs for two reasons: 3. first, if a business borrows on a long term basis, its interest costs will be relatively stable overtime, but if it uses short term debt, its interest expense can fluctuate widely, at time possibly going quite high 4. second, the principal amount on short-term debt comes due on a regular basis (one year or less) -if the financial position is not good, it may find itself unable to pay the debt when it matures -furthermore, the business may be in such a weak financial position that the lender will not extend the loan

cost of equity

1. the cost of debt is based on the return (interest rate) that lenders require to provide debt financing and the cost of equity to investor-owned businesses can be defined similarly 2. it is the rate of return that owners require to provide equity financing to a business 3. this return comes in the form of dividends, bonuses, or capital gains (selling the ownership interest for more than its cost) 4. before the investment is made, equity investors set a minimum required rate of return based on the riskiness of that investment--the higher the risk, the higher the required rate of return -this required rate of return on an ownership investment in a business defines its cost of equity

interpreting the corporate cost of capital

1. the costs of debt and equity that make up a business's CCC are based on the returns that investors require to supply capital to the business 2. thus, if the business cannot earn at least the CCC on its real asset investments, it cannot pay the minimum returns required by its capital suppliers 3. from a pure financial perspective, if a business (especially investor owned) cannot earn its CCC o new land, buildings, and equipment investments, no new investments should be made and no new capital should be raised 4. the primary purpose of estimating a business's CCC is to help make capital investment decisions -the cost of capital will be used as the minimum return necessary for a new product or service to be attractive financially 5. the CCC reflects the aggregate risk of the business -only can apply the decisions with average risk -the CCC must be adjusted to account for the differential risk when the project is being evaluated

cost of debt

1. the exact types and amounts of debt that will be used may not be known. the type of debt will depend on the specific assets to be financed and on future market conditions -however, a firm's managers do know what types of debt the business usually issues 2. cost of debt: the return (interest rate) required by lenders to furnish debt capital 3. note that the appropriate is today's rate

combining the component costs

1. the final step in the process is to combine the debt and equity cost estimates to form the corporate cost of capital (CCC) 2. each business has a target capital structure in mind 3. furthermore, when a firm raises new capital, it generally tries to finance in a way that will keep the actual capital structure reasonably close to its target overtime CCC = [Wd X cost of debt x (1-T)] + [We x cost of equity] Wd: target weights for debt T: business's tax rate We: target weight for equity 4. note that the before tax cost of debt is reduced by (1-T) in the formula -this calculation recognizes that the interest expense is tax deductible for a for profit business 5. NFPs formula is the same but T = 0 -the starting cost of debt is lower because their tax exempt

capital

1. the funds used to acquire a business's assets, including land, buildings, equipment, and inventories 2. capital comes in two basic forms: debt and equity 3. most healthcare organizations use some debt capital, which is provided by lenders such as banks 4. alternatively, equity capital is furnished by the owners for investor-owned businesses or by the community at large not-for-profit businesses

capital structure theory

1. the goal of these theories is to determine whether or not businesses have optimal capital structures

setting interest rates

1. the interest rate is the price paid to obtain debt capital (cost of borrowing money) 2. factors that influence interest rates: risk and inflation

capital structure

1. the mix of debt and equity financing used by a business 2. often expressed as the percentage of debt financing

important factors managers must consider: business risk

1. the risk inherent in the operations of a business, assuming it uses no debt financing (risk with just being in business) 2. this risk is associated with the ability of managers to forecast future profitability 3. the more uncertainty in the process, the greater the inherent risk of the business 4. when debt financing is used, owners must bear additional risk above the inherent business risk of the organization -the additional risk: financial risk -additional risk when debt financing is used 5. in general, managers place some limit on the total amount of risk, including business and financial, undertaken by a business 6. thus, the greater business risk, the less room for financial risk in the optimal capital structure

setting interest rates: risk

1. the risk inherent in the prospective group practice (ex) and thus in the ability to repay the loan, affects the return lenders will require 2. lenders will assess the likelihood of the practice earning enough to make the required payments in full and on time 3. if they determine the practice is highly likely to achieve this level of earnings, the loan carries minimal risk for the lender 4. on the other hand, if the practice (ex) is having difficulties making the loan, the lender faces a higher risk on making the loan 5. lenders are unwilling to lend to high risk businesses unless the interest rate on such loans is higher than on loans to low-risk businesses

not for profit businesses capital structure

1. the same general concept we have discussed applies to not for profits-some debt financing is good, but too much is bad 2. debt financing permits not for profits to offer more programs and services than are possible using only equity financing 3. too much debt financing brings more risk to the owners (in this case the community) 4. not for profits have a unique problem: they cannot sell equity to raise new capital -for profits have the ability to adjust their capital structure while not for profits do not -therefore, not for profits sometimes must delay new programs or services, or temporarily use more than the optimal amount of debt financing because that is the only way that needed services can be provided

Equity financing

1. the second primary source of capital to healthcare businesses is equity financing 2. equity financing is provided by owners in for profit businesses, and by religious or governmental entities or the community at large in not-for-profit businesses 3. partner capital: paying into business

identifying the Optimal Capital Structure in Practice

1. the trade-off theory cannot identify the optimal capital structure for any given business because the costs and benefits of debt financing to a specific business cannot be estimated at alternative capital structures with any precision -thus, healthcare managers must apply judgment in making the capital structure decision

financial leverage

1. the use of debt financing 2. the use of debt financing, which typically increases (leverages up)

Impact of debt financing on risk and return

1. to begin the analysis (which financing option), note that the asset requirements for any business depends on the nature and size of the business rather than on how the business will be financed 2. the most important aspect for the owners is the ROE

bond category: government bonds

1. treasury bonds 2. to raise money for the federal government 3. generally held by financial institutions like mutual funds

debt contract: borrower defaults

1. usually, the debt contract spells out the actions that can be taken by lenders when this occurs 2. regardless of the contract terms, upon default, lenders have the legal right to force borrowers into bankruptcy

the choice between long-term debt and short-term debt

1. what is the optimal mix of debt maturities? 2. what is the optimal debt maturity structure? 3. the answer involves a trade-off between risk and return 4. in general, the optimal debt maturity structure involves matching the maturities of the debt used with the maturities of the assets being financed -rationale, the short term debt meets a temporary need, while long term debt will meet a more permanent need 5. in theory, the financing could be exactly matched to its assets' maturity -impractical because: the duration of assets' lives is uncertain, some equity capital must be used, and this capital has no maturity

trustee

1. when debt is supplied by a single creditor, a one to one relationship exists between the lender and borrower 2. bond issues can have thousands of buyers (lenders), so a single voice is needed to represent bond holders -this is performed by a trustee, usually an institution such as a bank, which represents the bondholders and ensures that the terms of the contract (indenture are carried out

Ch. 8

Business Financing and the Cost of Capital

Return on Equity

net income / owners equity 1. the key to the increased ROW is that although profit decreases when debt financing is used, the amount of equity needed also decreases and the equity capital requirement decreases more than the profit does 2. the bottom line is that debt financing can increase owner's expected rate of return 3. because the use of debt financing increases, or leverages up, the rate of return to owners, such financing often is called financial leverage 4. the rate of return to owners 5. the use of financial leverage increases not only the owners' return but also projected their risk 6. thus, the decision as to how much debt financing to use is a classic risk-return trade-off: higher returns, more risk