FINANCING OPTIONS AVAILABLE TO ENTREPRENEURS - PART III (CASE STUDY - PRACTICAL EXAMPLE)

CASE STUDY

In order to fully understand how the choice between debt and equity affects potential profitability of a business let’s consider a fictitious company called ABC  a new firm that is still in the process of raising funds/capital to start up their business.

In this case the owner already has N 100,000 of their own money and need an additional N 100,000. They are considering two options to raise the additional capital. One of which is to approach investors to provide N 100,000 for a 30% share of the firms outstanding stock or approaching a bank that would lend them N 100,000 at an interest rate of 8% so the interest expense would be N 8,000 (0.8 X N 100,000).

The firms operating income (earnings before interest and tax) is expected to be N 28,000 as determined as follows:

With the additional N 100,000 in equity or debt the balance sheet would appear as follows:

In order to keep things simple for this case we would assume there are no taxes and so with the above information we can project the firm’s net income when the additional N 100,000 is financed by equity or debt as follows:

From the above it is clear that the net income is greater if the firm’s finances with equity as opposed to debt but the owners have to invest twice as much to avoid an N 8,000 interest expense to get the higher net income.

The question then is “do owners always need to finance with equity to get a higher income?” the answer is not necessarily as the return on investment or return on equity is a better measure of the performance than the absolute Ringgit amount of the net income.

The return on equity from equity financing is 14% while that of debt financing is 20% as seen below:

 It can be seen from the above that Company ABC’s return on equity is higher if half of the funds comes from equity and the other half from debt. By using only equity ABC’s owners will earn N 0.14 for every N 1 invested but will earn N 0.20 for every N 1 if financed with debt. So in terms of return on investment/equity ABC’s owners get a better return on investment by borrowing money at 8% interest than using equity financing.

As it has been shown that debt financing is beneficial to a start-up business, some might ask why the owners of company ABC do not use more debt financing and if possible 100% Debt financing which would make the rate of return on owner’s equity investment much higher or even unlimited if they did not invest anything at all.

The problem with this scenario is that increased debt financing though tempting is very risky. In the event that the firm fails the creditors still demand payment and in extreme cases can force a firm into bankruptcy. In this regard equity finance is less demanding as if the firm does not reach its profit goals and equity investor must accept the disappointing results and hope for better the next year.

Another attraction to debt financing to the owners of company ABC would be the fact that it enables them full ownership of the company without having to give out a part of the company.  As stated in the first chapter this would depend sole on the personal preferences of the owners of company ABC.

LOOK OUT FOR PART IV - THE CONCLUSION