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Your consulting team has been hired to evaluate the financing of a new project. The company wants to fund the project with either debt by borrowing the money or equity by selling additional common stock. The company does not want a combination of debt and equity financing, nor do they want any exotic financing such as convertibles, debentures, warrants or bonds. Its simply debt versus equity. The companys CFO (me) will listen to your presentation and ask you questions concerning your recommendation. By the way, you are the consultant, so do not recommend hiring another consultant. Final Project Finance 4873 Debt vs. Equity Financing Your consulting team has been hired to evaluate the financing of a new project. The company wants to fund the project with either debt by borrowing the money or equity by selling additional common stock. The company does not want a combination of debt and equity financing, nor do they want any exotic financing such as convertibles, debentures, warrants or bonds. It's simply debt versus equity. The company's CFO (me) will listen to your presentation and ask you questions concerning your recommendation. By the way, you are the consultant, so do not recommend hiring another consultant. Assumptions and Considerations: The type of project will depend on the company you select so the project has to \"make sense\" in relation with the company's current business plan. To determine the company's current mission and financials, you will need to download information from the SEC site: www.sec.gov. Or Yahoo Finance. Or PriceWaterhouseCoopers has Edgar data that can be downloaded into word or Excel, at www.pwcglobal.com. Information and links can also be found at Yahoo.com. You will need: The latest 10-K (annual report) provides the business plan and detail financial data such as depreciation schedules and debt profile The latest 10-Q (quarterly report) for updated financial information. The most recent 14Def (proxy statement). This information may be included in some 10Ks for smaller companies and lists ownership, which could be a factor in the decision. Is the company controlled by insiders or do institutions own a majority of shares? The latest stock price to determine cost per share. The latest ratio and growth analysis from on-line financial reporting services for the company and the industry. RMA's Annual Statement Studies (in the UTSA library) has a large number of industry average financial ratios. Reuters www.reuters.com also has a listing of company vs. industry ratios. The new project can range between 35 percent of the company's total assets to 15 percent, depending on the ability of the company to grow at the level of new assets selected. If the team decides on debt to fund the project, then funding for a loan will be for 5 years and a debt rate computed at: Prime Rate plus project risk % (probably in the 1-4% range). There should be a reasonable test of the loan in relationship to the rate that the company currently pays. This usually can be found in the 10-K. If the team decides to issue new stock to fund the project, then costs of issuing new stock such as the investment banker's fee as well as possible dilution, or discounting, of the stock price must be considered. The team will create pro forma operating cash flows for the project that will forecast financial models for debt and equity for 5 years, or less, or more, if needed. Balance Sheets for first year (time 0) only should reflect current structure, proposed structure under debt scenario and proposed structure under equity scenario. Recommended Steps: The first calculation will be to determine the current capital structure, the structure under debt and the structure under equity. Next you will calculate the WACC under the current structure using book value of debt and market value of equity. For the equity required rate of return, use CAPM or the Gordon Dividend Growth Model, if applicable, depending on the beta and/or the dividends issued. Step 2: Determine the cash flows for the project to calculate IRR, NPV under current WACC capital structure. If the project is longer than five years, then the terminal fifth year should include sale or salvage of the project. If the project is a going concern, the recommended terminal value is the final year's Net Income divided by the current WACC. (The project in future years may be fully depreciated, thus not added back. So Net Income is used.) The easiest method to determine operating cash flows is the percent of sales method. If the project is similar to the company's main product line, take the same percentage as used for the assets for the first years' sales. Cost of goods and G&A will be the same percentage as the company. The depreciation can be straight line for 10 to 20 years (or the average for the company), with the years representing an average of plant and equipment in the project. After net income, add back the depreciation for the operating cash flows. Calculate the NPV and IRR. This isn't necessary, but: Step 3. The team brings the cash flow calculations, WACC, NPV and IRR to class for the instructor's inspection. Failure to do this will adversely impact the grade. Once the decision has been made to fund the project, then begin the process to exam debt vs. equity. The WACC employed was under the current capital structure. How does that change under the debt or the equity scenarios? Does it help one case or the other? If more debt is employed, how will it affect the debt rate? Consider the project cash flows, how do ratios such as EPS or ROE change under debt or equity. (Do not recalculate NPV, but note the effect of NPV on a change in WACC or risk. Also the IRR is based on cash flows, not financing, thus it never changes.) It's simpler to stick with project cash flows, then merge the project into a consolidated pro forma income statement to determine debt or equity. After the project is integrated into the company's regular operations determine ratios, such as TIE and ROE and EPS under debt or ROE and EPS under equity. Note under the debt scenario, the project's interest is increased while the number of shares stays the same. Under the equity alternative, no additional interest is included, but the shares increase because shares are sold to finance the project. Although under equity, there is the investment banker fee to consider and the stock discount that the banker will use to sell the stock the team will need to calculate the number of new equity shares. Another issue could be the P/E ratio. A high P/E ratio means less stock dilution. A key issue under equity is if the project is the accretive. Reasonableness test for project revenues and costs: Calculate the DuPont Identity (Net Profit Margin*Total Asset Turnover*EquityMultiplier = ROE) on the original company statements and the project cash flows, where applicable. This test should show if the project projections are within reason. For example, if the TA Turnover of the original data is 1, meaning $1 in sales for $1 in assets, and the project cash flows' TA Turnover is 4, meaning $4 in sales for $1 in assets, then the project is not reasonable unless the risk factors are drastically altered. Charts and graphs will be helpful to explain the decision. Your team needs a written presentation of at least three pages. All data calculated should be filed in the appendix. This means scenarios under debt and equity, balance sheets, etc. Also all work papers such as separate calculations for such items as depreciation allotments and schedules, WACCs, NPVs. Depreciation assignments means, for example, how much of the project is going to various asset classes, such as machines, equipment, building and land. The written report with ALL work papers must be turned in at the beginning of the presentation. APPEARANCE IS IMPORTANT. The presentation, however, will be in Power Point slides, copies of which must be in the appendix. The oral presentation will include a brief description of the company, the project, the financial data, the interpretation and the recommendation. It is not necessary to show all financial data, but only the data relevant to the presentation. Power Point slides should not be more than four short bullet items. Or four rows by four columns The presentation should not take longer than ten minutes, and each team members must participate by explaining a portion of the presentation. All team members must be ready to explain and defend any calculation in the presentation. For example, I may ask a team member to explain how the WACC was calculated, and the explanation would be step by step of the formula and its components. Notice: Once the presentations begin, no one will be admitted to the room. That means you must have presentation ready to go at the beginning of the class. Roll may be checked. Students who do not attend the day, in which they do not have a presentation, will have their grade lowered. Teams that do not present on the day scheduled and in the order selected will have 20 points deducted from the grade. If a team member did not participate, this fact will be reflected on the Peer Evaluation that will be filled out by each team member and will severely impact the non-participating student's course grade