Managing Risk through a Global Capital Strategy by James W Blake - Article Example

Managing risk through a global capital strategy by James W. Blake Synopsis of content  This paper looks at the financial situations of hospitals (especially in US) and suggests that new market structures after the financial crisis of 2007-2008 call for different and improved risk management measures and the effect of debt on its capital structure. Back in 1958 in the Economic Review Modigliani and Miller proposed two very different optimal capital structures and since then there has been much debate going on as to what exactly is an optimal capital structure. Their first proposition concludes that in economic equilibrium conditions and perfect capital markets on which there is no tax liability, a firm is independent of an optimal capital structure to maximize its value. Five years after that, in 1963, they propose a different theory stating that introduction of corporate taxes provides a tax shield for debt that can escort a firm that is financed with 100% of debt. This props further questions like; aren’t firms wasting tons of money in tax payment to underuse debts (assumptions are; bankruptcy costs moderately) or other factors can take part in diminishing debt’s tax advantage? One such factor is the personal-corporate tax interaction where slightly different treatment of equity and debt (at personal level) that lessens the observed debt value. Corporate tax advantage is fractionally balanced by personal tax disadvantage by paying interest payments (Miller, 1977). The good thing is it confirms to both Miller and Modigliani. If there are no tax disadvantages then debt level returns back to the levels defined back in 1963. On the other side, advantages of debt get terminated by terminating personal equity tax. Personal income tax rate becomes equal to marginal corporate rate while suffering losses at corporate level. Probably in the long run, a capital structure under these forces may not be of much help in explaining the phenomenon of optimism but when tax code and variations are considered, business risks help explain the short term optimal capital structure of a firm. The capital structures constructed by health care providers have both negative and positive effects on the hospital business and success of organization. These capital structures built by combinations of debt and equity are now relatively modified as compared to previous decades’. In the aftermath of financial crisis of 2007-2008, the volatile situation of stock market, interest rate indexes, innovations in financial products especially in OTC markets for bonds and derivatives and changing dimensions of credit markets present a new challenge for providers. Specification of thesis – main point  What is an optimal capital structure and what are the ways to determine an optimal capital structure of a firm? And how risk can be managed through a global capital structure? Risk is present all the time, in capital markets, which affects the capital structure of firms. So instead of avoiding it, a better strategy is to have well managed capital strategy in place. c) Three supporting opinions/reasons  1. Enterprise Risk Management Balance sheet risk management will always remain most important in overall financial risk management. A well established and well operated risk management for treasury practices is the major force in mitigating the financial stress of a balance sheet risk. Hospitals and health care facilities have different profiles and risk/return objectives with different market share and risk exposures, therefore there isn’t a standard capital structure that fits all. Every hospital and health care facility will need to have their custom made. One move that definitely fits almost all health care providers is to have a global capital strategy. A strong liquidity packed with position low forward capital needs would probably call for floating rate debt and appropriate interest rate swaps. 2. Cash and debt Different firms have different approaches towards their cash balances and investments, looking for surplus return to support the operations efficiency. Other firms look at investments for long term returns, something that they can rely on in longer term perspective for business support which keeps adding to their endowment principal. 3. Documentation Risk Approach Health care facilities look at risk under different perspectives incorporating capital structure risks. They rank their risks in ranks of market and organization. Documentation of risk approaches and plans help the organizations in keeping track of their priorities and capabilities helping both internally and externally which also helps in reaching the targets set out in the mission and vision statement to trim and manage their capital structure. d) Three opposing opinions/reasons  1. Risk Aversion Considering the current situation, many officers might be probing their directors and CFOs with questions like; why shouldn’t we just liquidate investments and take care of our debt with it? This will have positive effects for us as the hospital will pay all of its attention to improving its operation performance without having to worry about market volatility. And instead of sticking with debts of fluctuating rates, why not to get involved with fixed rate financial products? These questions are natural, considering the consequences of financial instability that the whole world went through during past 4 years. Every firm wants to minimize its capital structure risks as it did maximum damage to the firms during the financial crisis. But in this case, ignorance is not a bliss. Avoiding debt to be safe is not the safest approach. 2. Improper Evaluation of Debt Structure Improper evaluation of debt can lead to many problems and unstable capital structure. There needs to be a well-established strategy to bridge the gap between the existing debt structure and projected debt capacity. Having a weak liquidity position packed with high forward capital needs can put the company in tough financial situation. 3. Less Emphasis on Leverage Underestimating the importance of leverage disrupts the whole idea of an optimal capital structure. Debt securities are an excellent option to create leverage for the firm. Tax deductibility is the result of investing in debt securities which provides extra leverage. And the recent financial crisis proved that firm that were more flexible (had more leverage) suffered less losses as compared to the ones that were stuck in a rigid pattern of investments. e) Your summary and opinion of thesis I totally agree with the statement of thesis. Financial markets are changing at an unprecedented rate. There are various opportunities available for hospitals and health care facilities. Not knowing about them and avoiding them in the name of risk averseness is not the right way to go. Eventually organizations will need to cope with them, so the sooner the better. For instance, long-dated tax-exempt debt at the present moment is relatively cheaper than treasuries (rates of tax exemptions are comparatively high). But there are times that frequently come when long tax-exempt rates are fertile (low rates compared to treasuries), which was seen during the latter half of 2006. Hospitals (and other organizations) that were aware and equipped with information were in a better position to cope with the fluctuations of the financial markets. They immediately saw the financial variations and switched from variable-rate bonds to fixed-rate debt and then back to variable when the time was right. They switched their debt rates without taking on any additional event risk or bank renewal risk or put risk. They however were exposed to marking to market risk but overall their risk profile was considerably reduced and they didn’t suffer the mount of losses that others who didn’t switch their debt rates. As I have shown in the paper above, debt needs to be taken exactly according to the projected capital structure and now there are so many options available in the debt market (tax deductibility) that it is simply not an option to stay away from the financial market just to stay safe. In my opinion, hospitals and healthcare facilities need to go into the market and earn profits to create leverage. It is only the leverage that can save them from financial crisis. Insurance does not cover market risks; the only option is to have a well-managed and up to date capital structure strategy. Work Cited Miller. H, (1977). Debt and Taxes. Journal of Finance, 261-273 Blake, W. (2010). Managing risk through a global capital strategy: risk is ever-present in the capital markets. Rather than avoiding risk, hospitals need an effective strategy to manage it. Health Care Financial Management. Retrieved August 7, 2011, from http://findarticles.com/p/articles/mi_m3257/is_7_64/ai_n54958490/pg_4/?tag=mantle_skin;content Read More