Dental consultants throughout this country arguing against the grain of better economics recommend eliminating the debt service that they say is holding back their clients' practices.
Yards of advertising print exists promoting their consulting services on the premise that they can help dentists reduce or eliminate debt.1 In doing so, these consultants completely overlook the economic literature on the optimum use of debt for optimal investment decision-making.
We have the late UCLA economist, Jack Hirshleifer, to thank for the analysis that follows. 2
Commence a scenario where a dentist wishes to acquire a set of four practices in the Southern Florida area. The dentist has capital availability of $5 million, either in cash or borrowing, and either for the full amount of one or the other, or some proportion of each. When these two alternatives are connected, every conceivable use of the available capital can be depicted in a two-dimensional capital budget line.
This "budget line" is shown in the graph below. The budget line is the 45 degree straight line connecting $5 million of cash on the vertical axis with $5 million of borrowing on the horizontal axis.
Let us say that owing to the advice received from a consultant, arguing the dentist should keep borrowing to a minimum, that the dentist funds the South Florida acquisition at point S on the Budget Line using $4 million in cash and $1 million in borrowing. The economic benefit arising for the dentist from this choice of capital structure is indicated by Curve C. All space below and to the left of Curve C is inferior to the capital structure of position S. By the same reasoning, all space above and to the right of Curve C is superior to the capital structure of position S.
Therefore, were the dentist (against the advice of the consultant) to borrow another $1 million, he or she would move to position D and Curve E, above and to the right of Curve C. By parallel of reasoning, a $3 million cash and $2 million borrowing structure is superior for the dentist than $4 million cash and $1 million borrowing, and, as such, the additional borrowing should be encouraged.
Next, have the dentist borrow another $1 million moving him or her to point X and Curve A. Point X is above and to the right of point D, and is a preferred situation. Therefore, a $2 million cash and $3 million borrowing capital structure is superior to the original structure and the structure introduced to improve on the original structure. Point X is the optimal capital structure for the dentist, and an extra $2 million of borrowing should have been introduced to improve the economic benefit of a decision to acquire the practices in South Florida.
If the dentist moves beyond $3 million in borrowing, this would deliver a result below and to the left of point X, an inferior position. Here and only here are the dental consultants criticized at the outset of this article correct in advising their clients against the dentist utilizing debt.
I hope this article helps clarify for dentists the attraction of using debt for optimal decision-making, and redefines the position of the majority of dental consultant in this country who think debt is holding back their clients. It is only holding back their clients where the judicious allocation of cash against borrowing is excessive. Until that excessive point is reached, dentist should borrow and borrow gladly.3
Lastly, the shapes of Curves A, C, and E in the graph are a reflection of the risk-reward or risk averseness of a straw dentist purchasing the practices in Southern Florida. Different shapes representing different risk-reward outlooks exist for different dentists. Shapes exist that might make point S optimal with all other capital structures falling below and to the left of point S. Shapes also exist that might make a $0 cash and $5 million of borrowing the optimal capital structure. As a general rule, since borrowing encompasses the risk associated with default, the flatter the shape of a dentist’s curve for risk and reward the greater his or her appetite for taking on more borrowing; the steeper the shape, the greater his or her likelihood for taking on less borrowing.
This is why determining the objectives and goals of your client and mapping them into a risk-reward profile are essential prior to advising a dentist of the optimal capital structure for his or her dental practice. 4
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1 Sally McKenzie, “Is Debt Holding Back Your Practice,” Newsletter, January 30, 2015, available at: http://www.mckenziemgmt.com/managementtips/tips673.html
2 Jack Hirshleifer (1958). "On the Theory of Optimal Investment Decisions". Journal of Political Economy 66 (4): 329–352
3 No reference is made herein to the interest rate and/or longevity of a loan in contrast to the use of cash since market rates for loans are driven by the same optimal or equilibrium analysis as exists for determining the correct capital structure for a dentist in his or her decision-making. In other words, the existence of excessive interest rates on borrowing are impounded out of the scenario sketched in this article.
4 The shape of an individual’s preference for lower risk over higher return, or higher return over lower risk, has a long history of analysis going back to Adam Smith’s The Wealth of Nations, 1776. For a modern treatment, see Eugene Fama and Merton Miller’s The Theory of Finance, 1972, and the references on this subject contained therein, which, of course, includes the Hirshleifer source used in this article.