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Determining the Debt-Equity Mix Simulation

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Determining the Debt-Equity Mix Simulation

Post  Pete2002 on Mon Jan 25, 2010 3:19 am

El Café is a recently founded coffee shop with some very typical business decisions to make within the simulation. Decisions which include expanding communities, selecting a debt-equity mix, avoiding bankruptcy are all involved within this simulation to make the business a profitable one. Being in a business that has a relative as a potential investor, financial strife and capital it’s important to make sure the decisions that are being made are ones that are for the better of the company.

Within the first scenario that was to be completed the debt-equity mix that is involved with the company and it’s financing. The business partner, Uncle Jorge, offers to give all the money needed for the company as long as the finances will be going through him. With this decision it would give him a seat as a primary stockholder for the company and basically put all the control in his hands. After reading through the information provided within the summary, a 30% equity and 70% debt mix is the best to use because the interest rates are low and are available in the city, not to mention that the business has a tax exempt status. In order for the equity component to be low, the weighted average cost of capital would have to be low as well. Because the cost of equity is higher than the cost of debt this is a true statement. Typically debt helps a company save money on taxes being able to put it into the tax deductible category. The problem that you have to keep in mind is that since the company is tax exempt, the goal is to make sure that the ownership of this company does remain where it currently is. To be able to ensure that the equity will remain on your side of the table and not Uncle Jorge’s side, choosing a high debt, and low equity model is the key to remember.

Scenario two is the fact that an optimal expansion strategy to spread the company into multiple cities around the area is another decision that has to be made. In the simulation by choosing a 7 city expansion with an all dept option, I was able to find out that this would be the most viable option for the time being since the rate of return is high and the weighted average cost of capital is low. When having a business, a decision that involves finances can only be justified if the expected rate of return is higher than that of the weighted average cost of capital. Since debt does cost less than equity does, and debt also does help to lower the weighted average costs of capital it’s easy to see the outcome. One other thing in the simulation is that taxes are no longer in exemption, the payments made on the business’s debt will help to lower interest rates and tax deductions can be applied. By doing this, the scenario starts the “tax shield” phenomenon of the higher the debt, the lower taxes; however bankruptcy starts to be a major threat and problem at this point.

In the last scenario the company must avoid the risk of going bankrupt. Many options are available that can be used in order to avoid this devastating problem Some of the options can include selling assets, renegotiating debt, and swapping debt for newly obtained equity. Debt and equity swapping is not the better option since it does raise the weighted average cost of capital without changing the base structure of the business and its finances. Most times this will not help in reducing the company’s debt. In most cases dealing with a business and bankruptcy, high debt for equity swaps can be difficult just because finding someone who will invest is not likely. The best option for the business would be selling real estate, which would allow for a substantial gain in money to pay off debt and then the land could be leased back at a later time and date. Renegotiating debt will not be the best solution because it is just a temporary solution. Having this option would just cause the interest rate to go higher and the predetermined rate of interest during the pay off period. Even though the interest rates would in fact drop again, it just would not be beneficial at this point for the company.

Weighted average cost of capital is important, in fact very important to the business just because it can be used as a type of indicator. What this is meaning is that if this particular figure is low, then equity will be optimal even if the debt is higher. On the other hand if the weighted aver cost of capital remains high, then the equity will likely remain low and could even potentially drop even if the debt is low and the equity is high. With the weighted average cost of capital impact and budgeting for business in this way it is used as an indicator for the future of the business. As well as operating expense decisions and goes with the debt and equity as well as reflecting the status of these by the size of their percentage.

In this simulation, El Café, is a company in the coffee industry that does face a very important decision that some businesses do face on a daily basis or at some point in time. The weighted average cost of capital is involved directly with the decisions within this simulation. In order for the business to be in better standings financially then the weighted cost of capital needs to be low. Having the weighted average cost of capital higher can cause a problem for the business especially if it is struggling with debt and or low equity.



References

Brealey, R.A., & Meyers, S.C. (2004). Fundamentals of corporate finance, 4th ed. McGraw-Hill/Irwin.

Pete2002

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