HCFM 10

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Kenyatta University School of Economics *

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MISC

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Finance

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Nov 24, 2024

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docx

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5

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Financial Management Question 1 The statement "the use of debt financing reduces the firm's net income; therefore, debt financing should only be used as a last resort" is an oversimplified view of corporate finance that does not completely convey the complexities and nuances involved in financial decision-making. While it is true that taking on debt can influence a company's net income, a broader perspective must be considered. Initially, it is crucial to acknowledge that the relationship between debt financing and net income is not always negative. Through the interest expense deduction, debt can offer a substantial tax advantage to a company. In many jurisdictions, interest paid on debt is tax- deductible, which can reduce a company's taxable income and, consequently, its tax liability (Raimo et al., 2021). This tax shelter can result in higher after-tax profits, which may exceed the debt's interest expense. Consequently, the impact of debt financing on net income can be both positive and negative, depending on factors such as the debt's interest rate and the firm's tax rate. In addition, the use of debt financing permits businesses to leverage their operations, which may result in increased returns on equity for shareholders. This leverage magnifies shareholder value creation when the firm's investments generate returns more than the cost of debt. Moreover, the notion that debt financing is a "last resort" ignores the strategic benefits of leverage. Debt can be a useful instrument for financing expansion, making strategic investments, or capturing opportune business opportunities. If a company relies solely on equity financing, it may be unable to capitalize on these opportunities. Nonetheless, it is essential to recognize that excessive debt can also result in financial distress, particularly if a company cannot meet its interest and principal payment obligations. Consequently, the firm's risk tolerance, cash flow
stability, and growth prospects should be carefully weighed when deciding whether to use debt financing. Question 2 Health services administrators in both investor-owned and not-for-profit healthcare organizations must make a crucial choice between debt and equity financing. In this complex decision-making process, multiple factors must be thoroughly considered. Capital Structure and Risk Tolerance play a pivotal role in this decision. Managers of health services must assess the current capital structure and risk tolerance of their organization. Profit motives may result in a higher debt tolerance for investor-owned firms, but they must also meet shareholders' return expectations (Moro Visconti & Morea, 2019). In contrast, non-profit organizations are mission- driven and may have a more conservative risk tolerance. These organizations' managers must achieve a balance between financial stability and mission accomplishment. The Cost of Capital is an additional important factor. The cost of debt versus equity financing should be compared by managers. Interest rates on debt are typically lower, but there are fixed repayment obligations, including interest payments and principal repayment. Equity financing, on the other hand, does not entail fixed financial obligations, but dilutes ownership and can result in a loss of control (Moro Visconti & Morea, 2019). The choice between these financing options should be guided by the organization's financial situation and long-term objectives. Also relevant are tax considerations, especially for investor-owned healthcare organizations. Generally, interest payments on debt are tax-deductible, which can reduce an organization's overall tax liability and make debt financing potentially more cost-effective. (Moro Visenti & Morea, 2019) Managers of health services must evaluate how debt financing
may affect their organization's tax position and financial performance. Cash Flow and Liquidity are major concerns, as debt repayment schedules can impair a company's cash flow. Managers must ensure that they can fulfill these responsibilities without jeopardizing vital operations or services. This factor is especially important for non-profit organizations, as they may not have the same financial flexibility as for-profit organizations. Relations with investors and donors are also essential considerations. The effect of taking on debt on shareholder relations and perceptions of a company's financial stability must be considered by investor-owned corporations before they incur debt. Maintaining the confidence of donors and grantors is essential for non-profit organizations. Any decision to use debt must be effectively communicated and consistent with the organization's mission and long-term viability. Regulatory and Compliance Considerations must be addressed as a final step. Regarding debt and equity financing, both investor-owned and nonprofit healthcare organizations must adhere to applicable laws and regulations. Managers of health services must ensure that their financing decisions comply with these regulatory requirements. Question 3 Estimating a company's corporate cost of capital is a crucial aspect of financial management, and it necessitates a thorough evaluation of all capital components. These factors contribute to the determination of the company's overall required rate of return to gratify its investors and meet its financial obligations. When estimating a company's corporate cost of capital, the cost of debt (Rd), the cost of equity (Re), and, in some cases, the cost of preferred stock (Rp) are the primary capital components typically considered. Each of these components represents the capital sources utilized by the business to finance its operations and investments.
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The cost of debt (Rd) is the expense incurred when obtaining funds. It includes the interest rate on loans or bonds, as well as any fees or transaction costs associated with the issuance of debt. The tax deductibility of interest payments on debt can reduce the effective cost of debt financing for companies. Therefore, Rd is impacted by current interest rates, the firm's creditworthiness, and the terms of its debt instruments. The cost of equity (Re) is the expected rate of return on investments by equity investors. Estimating Re requires several models, including the Capital Asset Pricing Model (CAPM) and the Dividend Discount Model (DDM). Re is influenced by the beta (a measure of risk) of the firm, the risk-free rate, and the market risk premium. Due to the larger level of risk associated with equity investments, the cost of equity is typically greater than the cost of debt. The cost of preferred stock (Rp) represents the dividend rate anticipated by preferred shareholders (Reiter & Song, 2021, p. 494). Preferred stockholders have a greater claim on the company's assets than common shareholders, but they rank below debt holders. Consequently, Rp is typically greater than Rd but less than Re. The corporate cost of capital is calculated using the weighted average cost of these capital components (WACC), where the weights are based on the proportion of each form of capital in the firm's capital structure. The WACC is the minimal rate of return a company must earn on its investments to satisfy all its capital providers, including debt holders, equity investors, and preferred stockholders. It is essential to observe that the corporate cost of capital varies among businesses. It varies from company to company due to several variables, such as industry differences, firm-specific characteristics, economic conditions, and market sentiment. Industries with higher perceived hazards often have a higher cost of capital, while well-established, financially secure companies may have a lower cost of capital.
References Moro Visconti, R., & Morea, D. (2019). Big Data for the Sustainability of Healthcare Project Financing. Sustainability , 11 (13), 3748. https://doi.org/10.3390/su11133748 Raimo, N., Caragnano, A., Zito, M., Vitolla, F., & Mariani, M. (2021). Extending the benefits of ESG disclosure: The effect on the cost of debt financing. Corporate Social Responsibility and Environmental Management , 28 (4). https://doi.org/10.1002/csr.2134 Reiter, K. L., & Song, P. H. (2021). Gapenski's Healthcare Finance: An Introduction to Accounting and Financial Management . Health Administration Press.