There are various ways in which a firm can finance its investments. This largely depends on the required capital mix of the firm. This paper gives an analysis of debt and equity financing in respect to Blue Jay limited which has previously been financed through debt capital. Further, it gives a recommendation on the appropriate mode of financing additional investments based on the firm’s capital structure.
Providers of funds do not gain any monetary interest from the business besides the principal and interest. Through this, the business owner is allowed to retain control and ownership of the business. However, in regard to taxation, the business enjoys some advantages since interest on debt is tax-deductible. Debt financing enhances future planning since principal and interest are calculated in advance. Besides the various advantages associated with debt financing, it also suffers a number of shortcomings which makes it less attractive (Thakor & Furlong, 1995). For example, investors are obliged to pay the agreed installments whether they have realized profits or not. In addition, debts may raise the company’s break-even especially if they are short-term loans that are more expensive. Ross observes that debt tends to restrict cash inflow since many lenders will be unwilling to lend additional money to debt-ridden firms. Also, the lenders will require the investors to provide security which is not always available thus limiting the chances of getting the much need finances.
The other form of financing is equity financing which entails investing in share capital for medium-term to long-term returns. Sometimes, equity finance tends to be the most appropriate mode of financing since once investors commit their funds in the business; it is not obliged to repay them except if its performance is outstanding (Szego, 1995). However, the business also stands a good chance of growth as a result of getting new investors who can contribute to new strategies for business development. More so, investors seem to maintain a close tie with the business. On the other hand, floating equity seems to be expensive in terms of time and costs. Further, the owner loses control of the business depending on the number of shares acquired by the new investors. Equity finance tends to be complex compared to other forms of financing since the business may be required to comply with some legal and regulatory requirements before floating its shares (Szego, 1995). Below are ratios that explain the effects of either using debt or equity as a means of raising additional capital.
Profit Margin = (Net Profit / Net Sales) x 100
Due to increase in interest expense, the net profit will reduce markedly. This will lead to reduced profit margin ratio thus making the business less favorable.
Return on Equity (Net Worth) = (Net Profit / Net Worth or Owners Equity) x 100
Return on Investment = Net Profit before Tax / Net Worth
The business will report reduced return on investment if it obtains a debt since the Net profit before tax will have reduced due to increases in interest
Net Income
Earnings per Share = ———————————————
Number of Common Shares Outstanding
If the company issues additional shares, EPS will reduce making the business less favorable in the eyes of other potential invest (Ross, 1989). If the company choses to finance expansion by acquiring more debt capital, it would have an adverse effect on the financial statements due to the increased interest charges. Presently, the company seems to be heavily indebted as shown by the interest expense. Acquiring more debt will tend to worsen the present situation since there is no guarantee that the helicopter will generate enough revenue to aid in offsetting the interest expense.
Alternatively, if the company’s considers selling part of its shares to new investors, it will have an effect of reducing the percentage of ownership. Funds will flow into the business and the advantage of this method over debt financing is that the firm will obtain funds to purchase the helicopter but it will not be obliged to repay. The company may only consider remunerating the new investors through dividends which are only payable from profits realized and/or retained (Modigliani & Miller, 1958).
In conclusion, Blue Jay Limited, having obtained other funds through debt financing, it could be appropriate to maintain a proper capital structure mix. This can be achieved by obtaining the required additional funding through equity financing. The firm can either look for a strategic investor and/ or float its common stocks for the public to purchase.
References
Modigliani, F. and Miller, M. (1958). The cost of capital, corporation finance, and the Theory of investment. American Economic Review, (June), 261-297.
Ross, S. A. (1989). Institutional markets, financial marketing, and financial Innovation. Journal of Finance, 44 (5), 541-66.
Szego, G. P. (1995). Risk-based capital in the European Economic Community. Journal of Banking and Finance, 19.
Thakor, A.V., & Furlong, P.W. (1995). Capital requirements, loan renegotiation, and the borrower’s choice of financing source. Journal of Banking and Finance, 19, 523-586.