The Entire Cost of Equity – A Case Study II

We recently ran across a situation where a business owner was wrestling with financing alternatives – specifically whether to complete an additional equity investment versus an asset based financing facility or perhaps a combination of the two.  We think this example is instructive for business owners considering the cost of financing alternatives.

 

Description:

 

The company in question is just a few years old and produces a highly reliable and sophisticated  information service that it sells to select industries who stand to reap significant rewards for having timely and accurate access to the information being provided.  The addressable market for the new product is large and the company’s product uniquely addresses a largely unmet need in the market.  The company has gained considerable experience in the technology and know-how necessary to produce the high quality information it provides to its clients.  The company also has developed a strong stable of clients and is currently growing its revenues rapidly.

 

The company has historically been funded through a combination of owner’s equity, third party equity and some debt financing.  It recently completed a small additional third party equity raise and restructured in remaining bank debt with the aim of amortizing fully within the next year.  The company maintains approximately $750,000 in accounts receivable (its primary financial asset) and expects to grow its A/R balance commensurate with its sales going forward.  The company is profitable, but continues to have large cash flow requirements associated with investing further in its technology and expanding its distribution capabilities.

 

Financing Question:

 

How best should the business owners optimize their cost of capital while at the same time gaining access to the cash flow to make the investments necessary to accelerate its growth?

 

Assessment:

 

To find the optimal solution to this problem, it is probably best to ask (and answer) the following two questions:

 

  1. Is the target balance sheet optimal?  If no, why?
  2. Are there any important economic or financial caveats that might change the answers the questions above?

 

First let’s take a look the company’s “Target” balance sheet and compare it to an “Improved” balance sheet.  (Btw – we’ll answer the question of why the “Improved” balance sheet is better in the next section):

 

Company Balance Sheet (12 months forward)

 

Target

Improved

Assets:

Cash                                                              $100,000

$100,000

Accounts receivable

$1,000,000

$1,000,000

Intellectual property

$1,000,000

$1,000,000

Total assets

$2,100,000

$2,100,000

Liabilities:

Accounts payable

$200,000

$200,000

Debt

$0

$800,000

Equity:

 

Invested equity (includes retained earnings)

 

$1,900,000

$1,100,000

Total liabilities + equity

$2,100,000

$2,100,000

 

The important thing to note is the two balance sheet structures above is simply that the “Target” is 100% equity financed and the “Improved” is financed with a combination of debt and equity.

 

We make the assertion above that the “Target” balance sheet is not optimal and offer an “Improved” balance sheet to show one we believe is better (i.e. maintains a lower cost of capital).  Let’s take a look at the following analysis to understand why the “Improved” balance sheet is materially less expensive for the company as compared to the “Target”:

 

Company Income Statement & ROE

 

 

Target

Improved

Sales

$5,000,000

Operating profit

$500,000

Interest expense (@ 10% interest rate)

($0)

($80,000)

Earnings before taxes

$500,000

$420,000

Taxes (@ 35%)

($175,000)

($147,000)

Net income

$325,000

$273,000

Invested equity (from balance sheet)

$1,900,000

$1,100,000

Return on equity

17.1%

24.8%

 

As evidenced in the income statements above, the company with the “Improved” balance sheet produces a Return on Equity that is nearly half again greater that with the “Target” balance sheet.  So at this point we know the answer to question 1, above:

 

  1. The “Target” balance sheet is not optimal from a cost of capital point of view and we can see this by noting the significant Return on Equity differential.

 

What about the answer to question 2?  We offer the following analysis and commentary to look at potential answers to this second question:

 

First an analysis – how much more expensive would the cost of debt financing (i.e. the interest rate) have to be for it to be an inferior solution for the company?  See the table below (please note that for example purposes, the only variable change in the table below is that of the interest rate):

 

Interest Rate

ROE

10%

24.8%

15%

22.5%

20%

20.1%

25%

17.7%

26.3%

17.1%

 

As demonstrated above, the interest rate on the debt would have to be greater than 26.3% per annum for the company’s cost of capital to be equal based on the two balance sheet options evaluated in this example.   Hopefully it goes without saying that that costs of debt in excess of 26.3% would result in an inferior solution for the company.  Certainly this seems a powerful demonstration of the real costs of financing decisions.

 

There are clearly a number of other considerations that could affect the analyses presented in this article – but any such impact would – from a financial point of view – most likely be at the margins.  In the end, the cost rationale for making certain capital raising decisions is frequently a compelling one.  Our counsel to this prospective client – of course solely from a financial point of view – is simply this:  To raise additional capital – not necessarily only as needed – but more so as can be productively deployed – through the issuance of either debt or equity – in whichever combination produces the lowest cost of capital.  And do not delay making high return investments unless you are simply not able to access the capital necessary to make investments at a price that will generate a positive marginal return.