Capital Budgeting Process
The purpose of this paper is to discuss how organizations issue bonds, the primary reason for leasing and short-term, long-term borrowing. We will also discuss the primary source of equity financing for not-for-profit healthcare organizations, capital budgeting as well as the discounted cash flow methods. Organizations that decide to issue bonds generally go through a series of steps; their function is to assess the relative risk associated with a given bond. A bond is loan to a company or government, with a person the bondholder, as the lender.
Organizations issue bonds when they want raise funds, generally you receive the principal called the par value, at maturity of the bond and interest periodically, depending on the market. The specific parties involved in financing a bond are: Issuing Authority Investment Bankers Healthcare Facility Market Trustee Bank Feasibility Consultant Legal Counsel Bond Rating Agency This issuing authority is only involved in tax exempt financing, in most cases the issuing authority is some state or local government authority.
Investment bankers have dual roles, they serve as advisors to the healthcare facility that is issuing the bonds; they serve for the focal point for coordinating the services of the feasibility consultant, legal counsel, and the bond rating agencies. Their advice can be extremely important to receiving timely funding under favorable conditions. Investment bankers serve as makers between the market and the issuer of the bond. Leasing is under taken primarily for major movable equipment and does not go through the normal review and approval system.
Lease payments should be considered as a capital expenditure. Contractual provisions of a lease should be kept in mind when determining the total expenditure amount, as well as future payments, length of term, or the alternative purchase price of the assets. Equipment depreciates, which affect your taxes, accounting procedures and various financial aspects of your company. The reason you should lease and how it will benefit your company are tax advantages, conserved capital, helps to stay within your budget, beats inflation as well as protect against obsolescence and preserves other credit acilities.
Leasing is one of the few remaining sources of fixed rate financing, there are clearly substantial economic attractions to leasing beyond tax benefits; is means to reducing business costs. Capital leasing is also an alternative to buying, this is a lease in which the lessor leases an asset for virtually all its economic life. In return, the lessee is committed to lease payments for the entire lease period. Financing is the other option; this includes getting a loan from a bank or other financial institution and paying it off over time with interest.
Short term borrowing may be used when a company experiences a short term need for funds during their operating cycle. Short term borrowing has different arrangements such as, single payment, line of credit, revolving credit arrangements, term loans and letter of credit. Usually, the portions of any loans due is to be repaid within a one year period. Long term financing is capital extended for a term longer than a year, long term financing is often in the form of a loan with a payback period, and it can include a 30 year mortgage or a 10 year treasury note.
Equity is another form of long term financing, such as when a company issues stock to raise capital for a new project. Some purpose of long term finance is to finance the permanent part of working capital, expansion of companies, increasing facilities, construction projects on a big scale, provide capital for funding the operations; this helps in adjusting the cash flow. Factors determining long term financial requirements are the nature of the business, nature of goods produced and technology used.
The kind of long term financing that is provided to a particular company depends on its type. Long term financing is used in separate ways by different types of business entities. The business entities that are not corporations are only suppose to use long term financing for the purpose of debt. A corporation can use long term financing for both debt and equity purposes. There are several sources of long term financing such as shares, debentures, public deposits, retained earnings, term loans from banks and loan from financial institutions.
The primary source of equity financing for not-for-profit healthcare organizations are contributions and philanthropy. Contributions can be given to a firm for a variety of reasons. In tax exempt healthcare organizations a contribution is given with no expectation of a future return. The donor may receive immediate or deferred tax benefit. The contribution may be in the form of a stock purchase or a limited partnership unit. This form of contribution can also be available to tax exempt entities through a corporate restricting arrangement.
Both taxable and tax exempt healthcare providers have used the issuance of investors as a means of equity financing. Capital budgeting occurs in several stages, there are certain classifications that are important to capital expenditures such as period during which the investments occur, types of resources invested, dollar amounts of capital expenditures and what types of benefits received. The capital budget is the yearly estimate of resources that will be expended for new programs during the coming year.
Capital budgeting may be considered as less comprehensive and shorter term than capital project analysis. Capital analysis occurs during the programming phase of the management control process, capital project analysis is the phase concerned with new programs. The capital budgeting process generally includes, Board of Trustee, Medical Staff, Management, and Chief Executive Officer. Capital budgeting is vital in marketing decisions, decisions on investments takes time to mature, have to base on the returns which the investment will make.
It would be to know what the present value (NPV) of the future investment; this will allow the appropriate person to evaluate the project. The 3 discounted cash flow methods are: Cost of specific financing source Yield achievable on other investments Weighted cost of capital The cost of specific financing source is used as a form discounted rate; the identified financing source is debt. An example of this would if a firm can borrow money at 10% in the bond market, that rate would be its cost of capital or discounted rate.
The yield rate on other investments, in some cases this rate might be equal to the investment yield possible in a firms security portfolio; this method is based on an opportunity cost concept. An example of this is if a company currently earned 10% on its investments, the 10% would be its discounted rate. The weighted cost of capital this is the most used method of defining the discounted rate. The WACC is calculated weighted average cost of capital= [debt/(debt+equity)*cost of debt]+[equity/(equity+debt)*cost of equity].
The advantage of this method is that it clearly represents the cost of capital firm, the problem with this is that the definition of the cost of equity. The initial cash flow should be carefully estimated and the cash flow present value needs to be evaluated. DCF is one of the most important concepts underlying financial decision making. The concept of discount cash flow is future, expected cash flows from a project or venture that has been adjusted to arrive at their present value. In conclusion I think that NPV is more widely used as a project evaluation method.
At the same time, I found out that financial flexibility and credit ratings were the most important factors in setting debt policy and that avoiding EPS dilution was the biggest reason for company’s reluctance to issue equity and that stock undervaluation was also important to equity issuance.