Explain How the Debt Capacity of the Governmental Entity Is Determined
Debt capacity fundamentally means the amount of debt that a company, individual, or government entity can repay without necessarily jeopardizing the timeline and the financial viability. It is, therefore, a measure of an entity's ability to borrow funds. Debt capacity differs across various industries and sectors. Some of the essential factors determining the debt capacity include the type, composition, and nature of assets and cash flows (Lee & Johnson, 2008).Debt is only presumed necessary when the value of a shareholder’s equity is much bigger than the financing cost. Debt capacity assesses the amount of money that an entity can borrow without facing financial problems. With regards to government agencies, many cities and states have restricted debt limits. For the purpose of discussion, the discussion will focus on the city of Seattle as the government entity in question. The legal debt capacity of the city currently stands at above $3.0 billion. However, the existing debt is at $2.6 billion. It, therefore, means that the city can go ahead and issue another $5000 million additional debt, but the only implication will be that this will decrease the credit rating of the city.
The city has several indicators that it uses to determine its debt capacity. Some of the factors include the population income and the value of the property. Population plays a significant role in determining what is known as the debt per capita. Using this indicator, the total population with debts will be taken and the value divided by the capacity to repay the debt. In the case of Seattle city, the most viable way to measure debt capacity using population would be to accumulate the available data showing the debts and dividing it with the entire population in the city. The total income of the city will also play a significant role in determining the city's debt capacity. Income, in this case, would be the total amount of money that the city would accumulate after providing goods and services. For there to be sustainability, the income must always be higher than the expenditure. A stable income shows a government entity’s level of debt capacity. The third important tenet that the city uses is known as the value of the property. The value of the property is the net worth of all the assets owned by the city (Lee & Johnson, 2008). A higher value of property correlates to a higher debt capacity and vice versa.
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Evaluate the Effect of Refunding or Reorganizing Existing Debt Obligations
Refunding is a method used in debt redemption. The government entity is forced to issue new bonds so that it can effectively raise new loans that it uses to repay the loans that have already matured. In essence, the government acquires a new loan so that it can settle an old debt that is already due. It involves the exchange of short-term for the long-term securities. It is, however, critical to note that this method does not relinquish the debt but rather accumulates it due to the postponement of the debt redemption (Van Frederikslust, 2012). There are several advantages associated with refunding including it allows an entity to acquire loans that can be paid at low-interest rates. Secondly, it can allow the extension of the maturity date for a period, and lastly, it can allow the government to revise its schedule. However, this only comes with short-term advantages as the government will only have extended the maturity period of the debt by a few months or years. The refunding can also result in what is known as the higher totality of the debts.
On the other hand, debt reorganization is a process whereby rearrangements are made between the lender and the debtor to create better terms of repayment. It is primarily used as a strategy to revive a firm that is experiencing difficulties to repay the debt. It is also used as an approach to extend the life of a company, firm, or any other entity facing imminent bankruptcy. Shibata & Tian, (2012) asserted that it is usually achieved as a result of a contractual plan or a consensus where the terms and conditions of debt are changed. It is, however, important to note that in most circumstances, the debt reorganization strategy benefits the debtor. Reorganization can be achieved in several ways. The first strategy is known as the debt assumption. In this situation, a new organization will take over and oversee the debt thereby becoming fully answerable for the debt. For instance, if the city of Seattle experiences massive financial problems or an imminent bankruptcy, the state of Florida can decide to take over the debts. However, it is important to note that Florida might still require Seattle to pay the debts even after changing the responsibility. The second major strategy that can be used is known as the debt restructuring. Essentially, the agency or entity under pressure to repay the debts will ask the lender for favorable terms and conditions to pay their debts promptly. As a result, the entity might end up receiving a lengthy period of payment and lowered interest rates (Shibata & Tian, 2012).
Analyze Various Funding Alternatives That Can Be Used To Support Debt Obligations
Before applying for a debt restructuring, a city or a state should strictly examine its economic policies to assess the adjustments it can make to ensure that it settles its debt obligations. A city such as Seattle can use taxation as a means of accumulating the required funds to settle its debts. It is important to note that government entities always remain keen not to default their debts. Therefore, it can resort to increasing the taxes charged on some of its commodities to raise the extra amount of money to settle the debt (Denis & McKeon, 2012). Such a strategy comes with several advantages including the fact that it is a reliable and efficient way of accumulating the funds. Secondly, it enhances sustainability and removes the relevant agency from a potential bankruptcy by facilitating a constant flow of cash. However, this will likely come with a toll on the city residents since the prices of commodities will substantially go up. The strategy might also affect the demand-supply curve as more taxes will impact the overall trade balance within the city.
Secondly, a government entity or even a company can resort to cutting its expenditure as a way of saving more funds to settle the preexisting loans. Such a strategy first requires an assessment of the expenditure and the evaluation of the least essential areas. For a city like Seattle, the most viable way would be to analyze its recurrent expenditures and find the areas that could be potentially slashed to raise money to settle the debt before it matures. Reducing expenditure would be advantageous because the government agency can determine the amount of money it wants. Furthermore, it is a reliable way of accumulating funds since it is initiated by the local government in question. However, it has two major disadvantages including the fact that it reduces government efficiency and can as well lead to discontentment and reduced morale on government employees especially when wages are affected (Denis & McKeon, 2012). Other viable ways of raising funds would be through selling and leasing property and improving productivity. A local government such as Seattle can resort to reshape its production landscape by increasing the prices of its commodities and increasing levies and tariffs for traders coming from outside regions.
References
Denis, D. J., & McKeon, S. B. (2012). Debt financing and financial flexibility evidence from proactive leverage increases. The Review of Financial Studies, 25(6), 1897-1929.
Lee, R.D. & Johnson, RW. (2008). Public budgeting systems (8th ed.). Sudbury, MA: Jones and Bartlett. ISBN: 9780763746681
Shibata, T., & Tian, Y. (2012). Debt reorganization strategies with complete verification under information asymmetry. International Review of Economics & Finance , 22(1), 141-160.
Van Frederikslust, R. A. I. (2012). Predictability of corporate failure: models for prediction of corporate failure and debt capacity. Springer Science & Business Media.
