Charles was always a hands-on type of person. Within a couple of years of graduating from college, he started his own business. After some 20 years, it has grown significantly. He owns and operates Pro-Fence, Inc. in the Metroplex, specializing in custom-made metal and stone fencing for commercial and residential sites. For some time, Charles has thought he should expand into a new geographic region, with the target area being another large metropolitan area about 500 miles north, called Victoria.

Pro-Fence is privately owned by Charles; therefore, the question of how to finance such an expansion has been, and still is, the major challenge. Debt financing would not be a problem in that the Victoria Bank has already offered a loan of up to $2 million. Taking capital from the retained earnings of Pro-Fence is a second possibility, but taking too much will jeopardize the current business, especially if the expansion were not an economic success and Pro-Fence were stuck with a large loan to repay.

This is where you come in as a long-time friend of Charles. He knows you are quite economically oriented and that you understand the rudiments of debt and equity financing and economic analysis. He wants you to advise him on the balance between using Pro-Fence funds and borrowed funds. You have agreed to help him, as much as you.

Charles has collected some information that he shares with you. Between his accountant and a small market survey of the business opportunities in Victoria, the following generalized estimates seem reasonable.

Initial capital investment : $1.5 million

Annual gross income : $700,000

Annual operating expenses : $100,000

Effective income tax rate for Pro-Fence : 35%

Five-year MACRS depreciation for all $1.5 million investment.

The terms of the Victoria Bank loan would be 6% per year simple interest based on the initial loan principal. Repayment would be in 5 equal payments of interest and principal. Charles comments that this is not the best loan arrangement he hopes to get, but it is a good worst-case scenario upon which to base the debt portion of the analysis. A range of Debt and Equity (D-E) mixes should be analyzed. Between Charles and yourself, you have developed the following viable options.

Debt Equity

Percentage Loan Amount, $ Percentage Investment Amount, $

0 ~ 100 1,500,000

50 750,000 50 750,000

70 1,050,000 30 450,000

90 1,350,000 10 150,000

Question:

For each funding option, perform a spreadsheet analysis that shows the total Cash Flow After Tax (CFAT) and its present worth (PW) over a 6-year period, the time it will take to realize the full advantage of MACRS depreciation. An after-tax return of 10% is expected. Which funding option is best for Pro-Fence? (Hint: For the spreadsheet, sample column headings are: Year, Annual Gross Income - Annual Operating Expenses, Loan interest, Loan principal, Equity investment, Depreciation rate (based on MACRS), Depreciation, Book value, Taxable Income, Taxes, and CFAT.)