Chapter 8 Healhcare Finance, Business financing and the cost of capital

what are the two primary types of capital available to healthcare businesses?

Debt capital (borrowed money supplied by lenders) and ownership equity capital (obtained from owners for a for-profit business or grants)

What is the price paid to obtain debt capital?

interest rates

what are the two most important factors that influence interest rates on business loans?

riskiness of the loan and inflation during the term of the loan.

why do lenders charge higher interest rates for loans to high-risk businesses?

Lenders need to compensate for the increased likelihood of not being repaid.

How does inflations impact the purchasing power of interest payment?

inflation erodes the purchasing power of money.

what measure is often used to track the increase in overall prices in the economy?

Consumer Price Index

What is long-term debt?

Defined as debt that has a maturity of greater than one year

What are the two major types of long-term debt used by health services organizations?

term loans and bonds

what is a term loan

a long-term debt financing that is arranged directly between borrowing business and the lender. Typically is amortized.

What is a bond?

is a long-term loan under which a borrower agrees to make payments of interest and principal on specific dates to the bondholder.

why would municipal bonds be attractive to investors?

Bond owners do not have to pay income taxes on the interest earned, making them tax-exempt.

what is the typical maturity range for bonds?

10 to 30 years

Why are bonds typically used intead of term loans?

Because of high admin. costs, bonds are not typically used for smaller financing needs, making them more suitable for larger projects.

what is short term debt and what is it used for

Maturity of one year or less, used for temporary needs/

what are advantages of short term debt

lower admin costs, fewer restrictions, and lower interest rates.

what is a significant disadvantaged of short term debt

subjects the borrower to more risk because interest costs can fluctuate widely, and the principal amount comes due more frequently.

What is a line of credit

short-term debt financing offered by commercial banks that specifies the maximum loan amount that a borrower can access as needed, usually with variable interest rates.

what are debt contracts and what do they outline

rights and obligations of borrowers and lenders

what are restrictive convenants in debt contacts

provisions in debt contracts designed to protect lenders from managerial actions.

what is a call provision in a bond contract

gives the borrower the right to call the bonds prior to maturity, typically when interest rates have fallen.

what do debt ratings reflect

the probability of default for major debt issuers and their specific debt issues.

Three primary rating agencies

Fitch Ratings, Moody’s Investor Services, and Standard & Poor’s

what is investment-grade debt

is debt with a BBB or higher rating, relatively low risk

what is junk debt

debt with BB+ or lower rating, considered more speculative.

Why are debt ratings important to borrowers and lenders?

the rating influences the interest rate required by lenders and many investors are restricted from investing in anything lower than investment-grade securities.

What is credit enhancement (bond insurance)

guarantees the payment of interest and repayment of principal on a bond if the borrower defaults.

how is equity financing provided in for-profit businesses

by stakeholders either directly through purchase of stock or indirectly through earnings retention

What is capital structure

is the business’s mix of debt and equity financing

What is return on equity

is net income divided by the book value of equity

what is financial leverage

the use of debt financing, typically increases the rate of return to owners

What is the “catch” to financial leverage

It increases the riskiness of the owner’s investment because of fixed interest payments and the obligation to repay principals

what is the trade-off theory of capital structures

the capital structure decision involves a trade-off between the costs and benefits of debt financing. It suggests that every business has an optimal capital structure that balances these factors to produce the lowest cost of capita

Can the optimal capital structure be precisely identified

No

What is business risk

inherent in business operations even when no debt financing is used, associated with the ability to forecast future profitability

what is financial risk

the additional risk to owners when debt financing is used

How do lender and rating agency attitudes impact capital structure decisions?

Lenders and rating agencies can set a limit on the proportion of debt financing a business can raise at reasonable interest rates, influencing capital structure decisions

why is maintaining a reserve borrowing capacity important

preserves a business’s ability to obtain additional debt financing for financial flexibility

how does asset structure influence capital strucutre

firms with assets suitable as collateral for loands tend to use more debt because they can obtain lower interest rates

what is a unique challenge for not-for-profit businesses regarding capital structure

they cannot easily sell equity or return earnings to equity investors/

what is the general guideline for optimal debt maturity structure?

matching the maturities of the debt used with the maturities of the assests being finances

how is the cost of debt estimated

current interest rate required by lenders to furnish debt capital

why is equity considered riskier than debt for investors

lenders have a guaranteed return, while owners have no guaranteed return.

how is the debt cost plus risk premium method adjusted for small businesses?

an additional small business premium is often added to account for the higher risk and lack of marketability of ownership.

why is the after-tax cost of debt used in the CCC calculation for for-profit businesses?

interest expense is tax deductible

how should the corporate cost of capital be used in capital investment decisions?

the CC sets the minimim acceptable rate of return (hurdle rate) for new capital investments with average risk

should the CCC always be applied without adjustments to all investment projects?

No, adjustments should be made for varying risk levels and project specifics.