Question

The mix of debt and equity financing used by an organization is called its capital structure. Many managers struggle with finding a balance between these two options. It is a critical decision as it impacts the organization's assets, liabilities, and bottom line.

You are the business office manager for Hope and Healing General Hospital. The radiology department is considering purchasing a new, high-tech diagnostic machine. It has a high resolution and has resulted in more accurate diagnoses. The machine costs $200,000 dollars. The three options for financing are obtaining a bank loan with interest (debt) for the entire purchase price, buying it outright with no debt, or using venture capitalists (equity). You have been asked to prepare a memorandum for the hospital's executive director with your recommendation.

In your memorandum, start out by reminding the executive director what debt and equity financing are. You will then comment on the pros and cons of each method. Also note which option you feel is the safest and which is the least safe option. Be sure to state why.

Answer 1

MEMORANDUM

To: Executive Director of Hope and Healing Hospital

From: Business Office Manager

Date: May xx 2020

Subject: Choosing the best alternative for financing the high tech diagnostic machine.

The Financing of an asset is considered to be the most crucial decision as it is concerned with the optimal allocation of funds so that it helps in improving efficiency and profitability. There can be different ways in which the financing can be done-

Debt-

Debt Financing means when a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to an individual or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise to repay the principal and interest on the debt.

Debt can be beneficial in a number of ways- You get to retain control, debt financing gives tax advantage and helps in easier planning as the expenditure is fixed.

But on the other hand, in order to receive debt at good interest rates, you need a good enough credit rating, and along with that by agreeing to provide collateral to the lender, you could put some business assets at potential risk.

Equity-

Equity financing is a method of raising funds to meet the liquidity needs of an organization by selling a company's stock in exchange for cash.

The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Equity financing places no additional financial burden on the company. Since there are no required monthly payments associated with equity financing.

But then obviously, in order to gain funding, you will have to give the investor a percentage of your company. You will have to share your profits and consult with your new partners any time you make decisions affecting the company.

Which is the best alternative?

Ultimately, the decision between debt and equity financing depends on the cost at which you are able to raise equity and debt and along with that what your competitors are doing. If you are considering selling equity, do so in a manner that is legal and allows you to retain control over your company.

Even you can use a mix of both types of financing, in which case you can use a formula called the weighted average cost of capital, or WACC, to compare capital structures. The WACC multiplies the percentage costs of debt and equity under a given proposed financing plan by the weight equal to the proportion of total capital represented by each capital type.

Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher than the cost of debt. So for the purpose of financing Equity is a safer option.

Yours Sincerely

Business Office Manager