Answer to Question #234426 in Financial Math for Md. Tanvir Hossain

Question

Your firm’s R&D department has been working on a new process that, if it

works, can produce oil from coal at a cost of about $5 per barrel versus a

current market price of $28 per barrel. The company needs $10 million of

external funds at this time to complete the research. The results of the research

will be known in about a year, and there is about a 50-50 chance of success. If

the research is successful, your company will need to raise a substantial amount

of new money to put the idea into production. Your economists forecast that

although the economy will be depressed next year, interest rates will be high

because of international monetary problems. You must recommend how the

currently needed $10 million should be raised—as debt or as equity. How

would the potential impact of your project influence your decision?

Answer 1

Advantages of debt financing: it allows a business to use a small amount of money in a much larger amount, providing faster growth than would otherwise be possible. The downside of debt financing is that creditors demand interest payments, which means that the total amount paid exceeds the original amount. Also, debt payments should be made regardless of the business income. For small or new businesses, this can be especially dangerous.

Equity financing refers to funds received from the sale of shares. The main advantage of equity financing is that the funds do not need to be returned. In this case, the business must be in debt to the shareholders and must bring a stable profit in order to maintain a stable valuation of shares and pay dividends. Since equity financing poses a greater risk to the investor than debt financing does to the lender, the cost of equity is often higher than the cost of debt. Finding a combination of debt and equity financing that provides the best financing at the lowest cost is the basic principle of any reasonable business strategy. To compare different capital structures, managers use a formula called the weighted average cost of capital or WACC. This allows enterprises to determine which levels of debt and equity financing are most profitable