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

Solution;

The brief points are as under:

Equity: Equity capital represents ownership capital, as equity shareholders own the company.

Advantages of Equity

• There is no compulsion to pay Dividends
• No maturity
• Enhances the creditworthiness (higher the better)
  

Disadvantages

• Sale to outsiders dilutes the control of existing owners
• Cost of Equity capital is high.
• Equity dividends are paid out of profit after tax, they are non tax deductible expenses (as against Interest), hence effective cost of equity is more.
• Cost of Issuing equity is higher
  • Underwriting expenses, brokerages etc.

DEBT

Debt financing involves borrowing a a certain sum from a lender, which is then paid back with interest.

Advantages

• Interest on debt is a tax-deductible expense
• No dilution of Control
• Payment is limited irrespective of how much company earns
• Cost of issue is lower

Disadvantages

• Failure to meet repayment commitments can lead to bankruptcy
• Debt financing increases financial leverage which raises the cost of equity
• Debt financing imposes restrictions on the firm
  

Also, any funding from internal accrucals is at par with equity funding.

Considering the current requirement  $200,000 it is advisable to use part debt and part equity to optimize the cost of funds and also avoid higher dilution. A DE ratio of 1:1 is a good option.

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