The “Cost of Capital” and Total “Cost to Own”

Two critically important concepts related to all your capital and purchasing plans and projections, “Cost of Capital” and total “Cost to Own”, are many times misunderstood.

“Free Cash” isn’t actually free at all.  Your capital has a cost whether it’s the cost of your long term bond financing, your shorter term capital equipment financing, receivables based cash flow line or any other money.  All your cash has a cost. 

It’s important to understand the cost of your capital before you start any project.  By definition, “the rate of return you would expect on a similar investment of equivalent risk”.  It’s not only the cost of borrowing because it’s also the cost of your equity.  The portion of your days cash on hand that makes up your ‘free cash’ over and above your expenses and debt service, still has a cost.  There are a number of ways to approach this and you should consult with your financial advisor to identify the most appropriate formula for your hospital or system. Using the simplest approach, your free cash arguably has a cost equal to your long term bond debt.  As long as that debt is outstanding, your cash used to service the principal portion and reduce your overall long term debt, will result in a reduction of interest owed at your current bond debt rate.

Another approach is to examine all your up-coming projects and compare.  If you plan to use cash for some and financing for others, what is the cost of financing for each project?  If you spend $8mm in cash to build out and equip a new Cyberknife unit and then turn around that same year and finance an $8mm building with a loan, your cost of capital for your $8mm cash spent on the Cyberknife project could be considered as the rate for your financing on the building.  There are many factors involved here and different asset classes so this example is merely meant to simplify the idea.

Comparing the cost of borrowing for both, inclusive of all fees and total “cost to own”, will help you analyze the best solution for your capital deployment.  If it will cost less to finance the Cyberknife project on a loan than it will to finance the building, perhaps you should consider the alternative. 

“Cost to Own” is simply the total sum of your payments related to a particular purchase and related financing.  A bond note at 4% on a 30 year amortization, 10 year term with a balloon, will have a much higher cost to own than a 5 year loan at 6%.  Your total interest over a 30 year amortization is much greater than your total interest over a shorter term such as 5 years, assuming an equal initial loan amount.  The question becomes, can you service the debt?  Assuming we’re not speaking about an interest only loan, your payments are higher on shorter term financing because you’re paying down the principal.  But your total cost to own is lower because you have less interest expense.  Your “cost to own” is not the purchase price for analysis purposes.  You have to factor in your “cost of capital.”

If you have ample cash flow, strong days cash on hand and a positive outlook, it makes sense to analyze your projects and consider shorter term financing.  Balancing your debt term length is a wise approach.  Too much shorter term debt will use up your cash flow and total allowed debt, outside of your bonds.  Too little shorter term debt will increase your total cost to own for many of your capital purchases and projects.

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