Cost of Capital. Debt and Equity Financing

Topic: Finance
Words: 613 Pages: 2

Debt and Equity financing

Debt and equity financing are the major sources of financing. The differences between the two are, first, debt investors are entitled to a contractual set of cash flow (interest and capital while equity investors have a claim on the residual cash flow of the firm. Secondly, interest paid to debt investors is tax-deductible while dividends are paid out of profit after tax. Third, debt has fixed maturity while equity ordinarily has infinite life. Finally, equity investors enjoy the prerogative to control the affairs of the firm while debt investors play a passive role (Chandra, 2005).

Advantages and disadvantages of equity

The advantages of equity financing are that it represents a permanent source of finance for the hospital, it does not carry a fixed burden and it enhances the creditworthiness of the hospital. On the other hand cost of equity is very high and the issue of equity to outsiders causes dilution of control (Hitchner, 2011).

Advantages and disadvantages debt

The advantages of debt financing are, first, the interest on debt is a tax-deductible expense. Secondly, it does not lead to dilution of control and finally, if there is a sheer decline in the value of the firm, shareholders have the option of defaulting on debt obligations and turning over the firm to debt holders. On the other hand, debt financing is an obligation to the firm as it has to repay interest and principal. Secondly, debt increases financial leverage which raises the cost of equity to the firm. Finally, debt imposes restrictions that limit the borrowing hospital’s financial and operating flexibility (Brigham & Ehrhardt, 2010).

Weighted Average cost of capital

Table1.0 Summary of information provided

2010 ($) 2011($)
Revenue 1,500,000 1,300,000
Equity 2,000,000 2,000,000
Third party payment 500,000
Grants 250,000
Operating cost 1,000,000 1,200,000
Debt 900,000 750,000
Pension plan 150,000 150,000
Malpractice 150,000 150,000
Depreciation 100,000 105,000

Computation of weights for different sources of capital

Source of financing Value in 2010 Weight in 2010 Value in 2011 Weight in 2011
1 Equity 2,000,000 0.6897 2,000,000 0.6154
2 Debt 900,000 0.3103 750,000 0.2308
3 Third-party services 0 0 500,000 0.1538
Total 2,900,000 3,250,000

Assume a tax rate of 30%, cost of equity is 12%, cost of debt is 6% and cost of third party payment is 8%. Values of sources of finances are assumed to be market value.

WACC (2010) = E/V * Re + D/V * Rd * (1-Tc)

0.6897(0.12) + 0.3103(0.06) *(1-0.30)


WACC (2011) = 0.6154(0.12) + 0.2308(0.06) + 0.1538(0.08) * (1-0.30)


Computations above are based on a few assumptions on the tax rate and the cost of debt and equity. The WACC for 2010 is 7.1% while in 2011 it is 7.3%.

Net present value of cash flows

Net present value is a technique used for the evaluation of projects. A project with a positive present value is considered viable and worth investing in. The table below summarized the cash flow expected in the two-year period.

Year Cash inflow Cash outflow Net cash flow Discount rate (10%) Present value of net cash flow
0 1,000,000 (1,000,000) 1 (1,000,000)
2010 1 1,500,000 1,000,000 500,000 0.9091 454,550
2011 2 1,550,000 1,200,000 350,000 0.8264 289, 240

In the table, the initial cost of investment is assumed to take place at the beginning of the year. Cash flows occur at the end of the year. Cash inflow comprises of revenue and grant received in 2011. Cash outflow comprises operating costs. The net cash flow generated from investing in the project is negative $256,210. This indicates that the project is not worth investing in as the cash inflows cannot cover the initial cost of investment and the operating cost.


Brigham E. F. & Ehrhardt M. C. (2010). The cost of capital. Financial Management Theory and Practice, 337- 346.

Chandra P. (2005). Sources of long term financing. Fundamentals of Financial Management, 15.2 – 15.5

Hitchner R. J. (2011). Cost of capital and rate of return. Financial Valuations Applications and Models, 228-229.

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