HCFM 10
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Nov 24, 2024
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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.
Related Documents
Related Questions
DEBT MAY BE BENEFICIAL IN CORPORATE GOVERNANCE FOR THE FOLLOWING REASONS EXCEPT:
Select one:
O a. BECAUSE OF THE DISCIPLINARY EFFECT ON MANAGERS
O b. BECAUSE THE INTEREST PAYMENTS BENEFIT SHAREHOLDERS
O c. BECAUSE INTEREST HAS TO BE PAID TO AVOID BANKRUPTCY
O d. BECAUSE IT REDUCES FREE CASH FLOWS
arrow_forward
Critique this statement: “The use of debt financing lowers the net income of the firm, and hence debt financing should be used only as a last resort.”
arrow_forward
Debt overhang occurs when:
1. A company is so indebted that it has little incentive to invest as all the cash flows generated by investments are expected to be appropriated by creditors
2. A company has plenty of free cash flows but few investment opportunities
3. A company issues debt to pay dividends to its shareholders
4. A company carries excessive debt, so that it has the incentive to invest in high risk projects at the expense of creditors
arrow_forward
QUESTION 15
Managers that structure financing transactions and choose accounting methods that exclude debt on the company’s balance sheet are using
hidden reserves.
fraudulent methods by default.
performance overstatement.
off-balance-sheet financing.
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Ch. 14. Which one of the following is NOT an implication of market efficiency for corporate finance?
Group of answer choices
Managers can reap many benefits by paying attention to market prices
Firms cannot successfully time issues of debt and equity
Managers cannot profitably speculate in foreign currencies and other instruments
Firms can successfully time issues of debt and equity
Managers cannot fool the market through creative accounting
arrow_forward
The disadvantages of debt to the corporation include all but which of the following?
Group of answer choices
A. Indenture agreements may place burdensome restrictions on the firm.
B. Interest and principal payments must be met regardless of performance results.
C. Debt may have to be paid back with "cheaper" dollars because of inflation.
D. Too much debt may depress the firm's stock price.
arrow_forward
In general, debt financing is _______ than equity financing. A firm’s ______ has priority in claiming the company’s assets.
Question 17 options:
1)
less costly, shareholders
2)
less costly, lender
3)
more costly, shareholders
4)
more costly, lender
arrow_forward
There are advantages and disadvantages of debt financing in contrast to equity financing. Which of the following is less likely to represent an advantage of debt financing?
a.
The cost of debt should be lower than the cost of equity for most companies due to the lower risk to the lender and the tax deductibility of interest
b.
The repayment of debt capital may affect the liquidity of the company
c.
If the return on assets exceeds the cost of debt, then this will result in a higher return on shareholders’ funds as compared to the return on assets
d.
The increase in borrowings will not normally affect the voting control of the current shareholders as compared to the issue of shares
e.
Fixed interest rate loans will result in the variability in the market value of such loans over time which will normally be less than the variability in the value of the equity of the company
arrow_forward
M&M Proposition II states that it is completely irrelevant how a firm chooses to arrange its finances.
True or False
arrow_forward
Which of the following is a disadvantage of long-term debt as a means of company financing?
Group of answer choices
Debtholders have preferential status in the event of a company being wound up.
Tax relief is available on interest payments.
Debt is often quicker to arrange compared to equity.
The amount and timing of interest payments is predictable, making budgeting easier.
arrow_forward
Is this statement true or false? Please explain in detail
As debt-financing is usually cheaper than equity financing, debt-financing will lower risk for transnational company.
arrow_forward
Balance Sheet Insolvency occurs when Liabilities are greater than the Assets resulting in negative capital equity. For a Financial Institution, Insolvency Risk can be defined as the risk that there is insufficient capital to offset either a decrease in the market value of assets relative to liabilities or an increase in liabilities relative to the market value of assets.
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B. Describe the best protection against insolvency risk at a Financial Institution.
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Which of the following statements is FALSE?
As debt increases, the risk associated with bankruptcy and agency costs is reduced.
Debt is often the least costly form of financing for a firm.
Firms should probably use some debt in their capital structure.
Different firms are subject to different levels of risk.
arrow_forward
p18
Which of the following is true of debt financing?
Firms whose sales are very stable are more likely to rely on debt financing than firms whose sales are volatile.
Firms that pay dividends are more likely to use less debt financing than firms that retain most of their current earnings.
Firms that are subject to a great degree of operating leverage are more likely to use debt financing than firms that don’t utilize fixed costs.
All of the above
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Debt financing is likely to appeal most strongly to organizations that have predictable profits and cash-flow patterns. Question 22 options: True False
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Please explain one advantage and one disadvantage of financing a company with debt.
Advantage Disadvantage
arrow_forward
2. If a bank wants to avoid volatility in its regulatory capital, which investment classification would be the
most desirable, and which investment classification would be the least desirable? Does your answer
differ depending on whether the bank is large or small? In other words, do large and small banks
differ on how they can categorize unrealized gains/losses on AFS debt?
arrow_forward
5.What is the major drawback of debt financing?
Select one:
You have to pay back the money
Increasing debt changes the gearing ratio of the firm
Interest payments must be made before shareholder dividends and irrespective of fluctuations in profits
Lenders often require security of the loan against assets of the company
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Related Questions
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