Capital Financing: Debt and Equity Financing

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Introduction

Every investment opportunity requires capital funding for it to succeed. When an entrepreneur seeks financing from an investor, the money can be given in the form of debt (bonds), equity (stock) or a combination of the two (Bellavitis et al., 2017). Businesspeople use the funds to meet the capital needs of the investment. Lenders expect to earn a return on investment on the bond and equity in the form of interests and dividends. Investors will be motivated to accept an investment that seems profitable from their projections.

An entrepreneur asks for $100,000 from an angel investor for purchasing a diagnostic machine. The investor intends to provide finance as 60% debt and 40% equity while the businessperson hopes for as much equity as possible. The costs of equity and debt are set at 16% and 9% respectively, with a project 9% as the return on investment in the first year. An after-tax weighted average cost of capital should be calculated with a marginal tax rate of 35%. From the scenario, this paper explores the dynamics of capital financing by answering questions related to debt and equity financing. It also examines the viability of the investment and the possibility of an angel investor taking it.

Tax Benefits of Debt Financing

Debt financing is one of the ways of raising capital for investments. According to the research by De Rassenfosse and Fischer (2016), it occurs when a company raises money for working capital or expenditures by selling debt instruments to investors. The lending party thus becomes the firm’s creditor and receives an assurance that the debt principal and interest will be repaid (Parrino et al, 2017). The main advantage of this financing method is that the interest part of the loan repayment is a tax-deductible expense for many institutions (Parrino et al, 2017). Therefore, it reduces the net income tax, which means its cash outflows drop.

Calculation of the AT-WACC

The cost of capital should be made of a 60% debt and 40% equity financing structure.

The After-Tax Weighted Average Cost of Capital (AT-WACC) is given as:

WACC=(V/E​×Re)+(V/D​×Rd×(1−Tc))

where E and D are the market values for the firm’s debt and equity while V, the firm’s total market value = D+E and Tc is the marginal tax rate. The terms Re and Rd are the cost of equity and debt respectively. Therefore,

Cost of capital =$100,000

                     Re = 0.16

                     Rd = 0.09 x (1-0.35) = 0.0585

AT-WACC= (0.6 x 0.09) x (1-0.35) + (0.4 x 0.16) = 0.0991= 9.91%

Viability of the Investment

At the end of the first year, the entrepreneur prospects a return on investment (ROI) of 9%, hence: ROI= 0.09 x $100,000 = $9,000. On the other hand, the After-Tax Weighted Average Cost of Capital (AT-WACC) of 9.91% is evaluated as: AT-WACC= 0.0991 x $100,000 = $9,910. From the above calculations for this scenario, the return on investment is lower than the cost of capital investment. The ROI is less since it has to cover the entrepreneur’s debt cost and that of equity, which is higher than the former, and, ordinarily, it is not a must for the entrepreneur to pay the equity amount. Therefore, it is not a viable investment opportunity for the angel investor.

Financial Restructuring to Achieve a Positive ROI

It is possible to attain a positive ROI when the cost of investment funds is less than profits from the investment. In this scenario, since the ROI is 9%, the AT-WACC, which is 9.91%, should be lower than the return on investment to make the latter positive. The value of AT-WACC can be lowered through financial restructuring. According to Twin (2020), financial restructuring is a corporate initiative taken by a firm with monetary challenges related to its debt management as a way of reducing financial drawbacks. If the weight of equity is reduced in the capital investment and the weight of debt is raised, then the value of AT-WACC will drop below the ROI. The decline in AT-WACC is attributed to the reduction of the equity amount in the capital investment. The Table 1 below shows a sample restructuring by adjusting the values of equity and debt but with that of the latter higher than the former.

Table 1: Financial Restructuring Scenario

Debt Equity Tax Rate After-Tax Weighted Average Cost of Capital
Cost 9% 16% 35%
Present Weight 60% 40% 35% 9.91%
Weight Adjustment 1 70% 30% 35% 8.90%
Weight Adjustment 2 80% 20% 35% 7.88%
Weight Adjustment 3 90% 10% 35% 6.87%
Weight Adjustment 4 100% 0% 35% 5.85%

From Table 1, it is deducible that the higher is the weight of debt in the capital investment, the lower is the weight of equity. Therefore, the four adjustment scenarios will result in an AT-WACC which is lower than the ROI, hence, making the latter positive.

Rationale for Choosing Debt or Equity Financing

As an angel investor, I would accept investment opportunity which can promise a positive return on investment. If the ROI is lower than the capital invested, it is not profitable to an investor, hence I would view the business as unviable. It means that for a high ROI, I should invest in sources which require less capital. In this opportunity, the debt is less than the equity amount, which results in a high AT-WACC and a non-profitable ROI. On the other hand, a high equity, which is more than the debt, is disadvantageous to a financier since an entrepreneur repays equity at their discretion. Therefore, it follows that to achieve an AT-WACC lower than ROI, the entrepreneur should acquire more debt than the equity. It is however, risky on the part of the entrepreneur to take more debts.

A viable investment requires that the debt proportion in the capital is increased and the rise would make the investment more costly to the entrepreneur in terms of repaying the debt. The risk of becoming bankrupt increases with more weight of debt in the capital. In the event the entrepreneur defaults repaying the loan, the Unified Commercial Code-1 (UCC-1) empowers the angel investor to seize his personal properties used as collateral to pay for the interest. When the debtor becomes bankrupt, the creditor can liquidate the former’s property to compensate for the amount given as a debt.

When signing a business loan contract in the US, the contracting parties must complete UUC-1 statements to deem the agreement effective. The statements are basically a notice by creditors to publicly declare their legal rights to acquire the debtor’s assets upon defaulting the borrowed amount. During the contract signing, the debtor has to provide their property which would act as collateral. A UCC-1 form also helps creditors to secure court orders authorizing them to take the collateralized assets. It is, therefore, not advisable for the entrepreneur to accept deals which would result in more debts as this would make the firm bankrupt.

Conclusion

This paper explores various aspects of capital funding in terms of debt and equity options. It established that debt financing is advantageous to a business based on taxation since the interest accumulated is tax-deductible. The after-tax weighted average cost of capital for the investment scenario was evaluated as 9.91% which was higher than the return on investment of 9%. This signified that the investment was not viable for the angel investor. The AT-WACC value was more than the ROI since the weight of debt in the cost of capital was less than that of equity. Hence, this paper proposes that for the investment to be viable, the weight of debt is supposed to be higher than equity’s since this would result in a positive ROI. However, as it is, the opportunity is not worth investing in since it is not profitable.

References

Bellavitis, C., Filatotchev, I., Kamuriwo, D. S., & Vanacker, T. (2017). Entrepreneurial finance: New frontiers of research and practice, Venture Capital, 19(1-2), 1-16. Web.

De Rassenfosse, G., & Fischer, T. (2016). Venture debt financing: Determinants of the lending decision. Strategic Entrepreneurship Journal, 10(3), 235-256. Web.

Parrino, R., Bates, T., Gillan, S., & Kidwel, D. (2017). Fundamentals of corporate finance (4 ed.). John Wiley & Sons.

Twin, A. (2020). Restructuring. Investopedia. Web.

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BusinessEssay. 2023. "Capital Financing: Debt and Equity Financing." January 17, 2023. https://business-essay.com/capital-financing-debt-and-equity-financing/.

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BusinessEssay. "Capital Financing: Debt and Equity Financing." January 17, 2023. https://business-essay.com/capital-financing-debt-and-equity-financing/.