Regal Cars has been manufacturing exotic automobiles for more than 50 years. It has always prided itself on its top-quality products and high levels of customer satisfaction. All Regal Cars are hand-built to the purchasers' individual specifications. In the past year, the popularity of Regal Cars has increased dramatically following a promotional campaign in which Regal provided complimentary cars to star members of the local NHL team. To meet the increasing demand, Mark Quaid, the president and largest shareholder of Regal Cars, is considering partially automating the production line.
To finance the conversion of the manual production line to a robotic system, Quaid will have to raise more than $1 million in capital. The company has been in the Quaid family for more than 50 years and Mark is unwilling to sell shares and risk diluting his family's equity in the business. As an alternative to equity financing, he has identified three potential sources of debt financing and has asked you to explain how each option would affect the company's financial statements.
Option 1—Bank loan
A national bank has offered to lend Regal the necessary funds in the form of a 10-year, 12% bank loan. Annual payments of $100,000 plus interest will be required. Because of the loan's size, the bank would require Mark Quaid to personally guarantee the loan with a mortgage on the family estate.
Option 2—Bond issue
Regal can issue 10-year, 10% bonds for the amount required. Currently, similar bonds in the market are providing a return of 10%.
Option 3—Lease
Regal can lease the equipment. The lease would require annual payments of $104,000 over a 10-year lease period. The present value of these payments, at an annual interest rate of 8%, would be $697,850. The equipment is expected to have a useful life of 12 years and to be worth about $100,000 at the end of the 10 years.
Required:
Prepare a memo to Mark Quaid discussing how each of these options would affect the company's financial statements. You should also include in your memo any other pertinent observations that could influence the financing decision he has to make.