The capital asset pricing model, or CAPM, is used to price an individual security or portfolio. The general idea behind CAPM is that investors should be compensated in two

Week 4 Lecture 3.html

Capital Structure

Capital structure refers to the proportions of debt and equity carried by an organization. This is an important consideration. For example, when an economy is going into recession, there is risk in carrying a lot of debt on the balance sheet. If income goes down as a result of the economic downturn, the organization may not be able to make interest payments and risks a default. In the same circumstance, in case of equity, dividends may be reduced without incurring default risk. Most businesses, whether for profit or nonprofit, have both types of financing on the books. It is the balance between them that is an important choice managers make. Each organization must consider both the risk situation and the cost of capital and decide on the balance at any particular time. The balance may change many times as conditions change. So what is the cost of capital? That is much of the topic of study in this unit and involves the interest rate that must be paid to the lender in the case of long-term debt or the dividend in the case of equity financing. In either case, the risk premium must be added, and this is usually around 6% for a large business that is stable. Adding the interest rate to 6% gives a rough estimate of the cost of capital. For a small organization, that would be about 15%. This means that any investment has a simple hurdle rate of about 15%, that is, the net income target for the investment to break even is 15%.

The choice between debt and equity financing is one type of risk–return trade-off. The use of debt financing can leverage the return to owners or, in not-for-profit firms, the return on fund capital, but it also increases the riskiness of the business. Long-term investment method and equity investment are both used extensively in healthcare, and it would be wise for you to begin to understand these methods.

 Resources:

Investopedia. (2016). Capital asset pricing model – CAPM [Video]. Available from http://www.investopedia.com/video/play/capm/

Week 4 Lecture 2.html

Equity Financing

Long-term financing is one way of raising capital. A second way is through equity financing. Equity refers to ownership, which is raised by selling stock in your organization. In case of a nonprofit organization, donations from the community are similar to equity. Equity financing has strings attached, but these are different from those of long-term debt financing. In debt financing, you must return the money over time; in equity financing, you must give up a portion of the ownership of the organization, maybe even a major part. This means that you have given up some of the say in the management of the organization. Instead of making interest payments, you will be expected to make dividend payments. That is, the new owner or the partial owner shares the profits of the organization. An important concept involved in equity financing is constant growth. The goal of the organization is to have dividends rise every quarter and the stock of the organization price rise in lockstep with the dividends. When this happens, the growth in dividends as a percentage of stock price is zero. If the dividends rose but the stock price fell, the dividends as a percentage of the stock price would rise a great deal. As long as the financials show that the organization is sound, people would see that it is paying high dividends and would be attracted to the stock, which would cause it to rise again. A look at the Standard & Poor's 500 or other market shows that the average dividend is 2%–3%. When a stock has a dividend of 15%, it indicates a very risky organization that may be on the verge of ruin.

 An important concept involved in equity financing is constant growth. The goal of the organization is to have dividends rise every quarter and the stock of the organization price rise in lockstep with the dividends. When this happens, the growth in dividends as a percentage of stock price is zero. If the dividends rose but the stock price fell, the dividends as a percentage of the stock price would rise a great deal. As long as the financials show that the organization is sound, people would see that it is paying high dividends and would be attracted to the stock, which would cause it to rise again. A look at the Standard & Poor's 500 or other market shows that the average dividend is 2%–3%. When a stock has a dividend of 15%, it indicates a very risky organization that may be on the verge of ruin. 

Week 4 Lecture 1.html

Long-Term Debt Financing

When you buy a house, you examine financing plans offered by banks and loan companies. The terms include options such as repayment over fifteen to thirty years and adjustable or fixed interest rates and may include points for origination or to buy down the rate. There are a lot of categories of closing costs. There was probably a review of your credit worthiness to determine if you could reasonably be expected to make the repayments. This area was overlooked in the housing crisis that occurred in 2008. If you build a house, there are construction terms and inspections to release funds for the builder and materials, followed by a conversion to conventional finance. There is a requirement for a loan to value down payment so that you have significant "skin in the game" or commitment to the project. All of this is true when a business finances the purchase of major equipment or construction of new facilities. However, there is another step that shows that the expense is the best one that can be made among the available alternatives, that is, the projected return is the best and the risk is the lowest. A hospital may have to decide whether to buy a new Magnetic Resonance Imaging (MRI) machine or build a new emergency room (ER) wing. It must decide which alternative will offer the most bang for the buck—the highest return—and, if it fails, not cause great harm to the financial health of the organization. While this may seem fairly straightforward from a financial perspective, realize that other executives will also want to explore the competition and the projected future of the community in terms of health and growth. The community likely has an economic development agency that has much of the information needed such as projections of businesses or colleges coming to town.

 Long-term financing is one way of raising capital. A second way is through equity financing. Equity refers to ownership, which is raised by selling stock in your organization. In case of a nonprofit organization, donations from the community are similar to equity.