The Entire Cost of Equity – A Case Study

We recently ran across a situation where a business owner was considering an additional equity investment versus an asset based financing facility.  We think this example is instructive for business owners considering the cost of financing alternatives.

Description:

The company in question is a new company with an exciting new consumer product.  The addressable market for the new product is large and the company’s product addresses a largely unmet need in the market.  The business owner is highly experienced in the product segment, but for the first time is launching a branded consumer product venture.  To date, the company has been financed entirely with owner’s equity – primarily from savings and mortgaging owned commercial real estate.  The company has secured purchase orders with several large national and regional retailers and is on the cusp of significantly ramping sales and in doing so, expects to expend considerable resources on the marketing and advertising necessary to drive the product launch.

Financing Alternatives:

The business owner is currently evaluating how best to finance the next – and first considerable – growth phase of the company.  The realistic options are twofold as follows:

  1. Take out an additional mortgage on his owned commercial real estate property, or,
  2. Enter into a accounts receivable financing relationship

Assessment:

The mortgage option will provide the business owner a lower nominal cost of financing – probably 5-6% – since the creditworthiness and interest rate is based primarily on the considerable equity in the property.  But this type of financing should be properly understood for what it truly is – an additional equity investment in the business – not different in substance than writing a personal check.  The accounts receivable financing facility would likely have a notional cost of 8-10% plus a small per invoice service fee.  Comparing these two options on a nominal cost basis will, however, yield an answer that from a corporate finance point of view, fails to properly consider the entire cost of the equity.

The proper corporate finance analysis of this situation is perhaps further complicated by the fact that the business owner does have the resources to make an additional considerable equity investment in the company – thereby being able to directly avoid the real cost of diluting his equity and the intangible cost of having to wrestle with governance and other complications associated with having a third party equity partner.

Yet as the Nobel Economist Milton Friedman famously said “there is no free lunch” – and while properly assessing of the entire cost of this equity investment may be somewhat clouded by certain of the facts – the costs do nonetheless continue to exist – even if seemingly (although not in fact) indirectly.

The following comparison will help make this clear:

          Company A                   Company B

Capitalization:

Equity                                                 $1,000                           $500

Debt                                                         -                               $500

Cost of Debt                                          NA                               10%

Income statement:

Revenues                                                            $1,000

Operating Income                                                $200

Interest Expense                                    NA                               $50

Profit before tax                                   $200                             $150

Taxes (35%)                                         ($70)                             ($53)

Net Income                                          $130                              $97

Returns:

Invested Equity (same as above)        $1,000                        $500

Return on Equity                                   13%                              19.5%

As evidenced above – and assuming there is no cost of dilution or intangible governance costs – you can see that two companies that are identical in every way – except that one is 100% equity financed and the other is financed with 50% equity and 50% debt – produce very different returns on equity – again solely due to the way they are capitalized.  The difference in the returns profile is significant – with Company B generating equity returns that are 50% better than those of Company A.  By any measure this is a marked difference.

There may be other considerations (i.e. not yet generating sufficient A/R that can be financed) for our prospective client that could tilt the equation towards the additional equity investment, but like Milton Friedman said – “There is no free lunch!”