Exceptional Service Grading Company Capital Infusion
The Exceptional Service Grading Company demands a $500,000 investment. It is currently a privately held company with less than 25 stockholders. Although the stockholders are not all related, they all know one other and see the company as a family enterprise.
We will explore different possibilities open to the firm in terms of capital cost and capital structure effects.
Option 1: Obtain Private Debt Financing
Private debt finance can be secured by borrowing from a lending institution or bondholders. Obtaining private debt financing has the effect of increasing interest paid on the loan, which reduces income on the balance sheet and statement of cash flows. The capital structure will also be adjusted, with the company’s total debt increasing by $500,000 and the cost of capital decreasing (Choudhry, 2004).
However, according to Volker (1997), private debt has several problems and dangers for the applicant. Missed repayments can create strain and possibly the termination of a relationship when a loan is offered by family or friends. Typically, the inference is Debt committed with a credit provider may result in high rates of interest (high cost of capital), penalties for late payments, or security requests (Nesbitt, 2019). Because of the large interest payment, I do not propose this financing option for Exceptional Grading service with existing high contract service cost and poor current ratio.
Option 2: Private Transfer of Partial Ownership
Investors that invest directly in private enterprises or engage in buyouts of public corporations cause public equities to be delisted (Slee, 2011). The consequence of the private transfer of partial ownership is that it influences job growth in the three years following it. Because the equity is increased by $500,000, the capital structure is transformed. Because stock is more expensive, the cost of capital rises (The Investopedia Team, 2021).
This option, depending on the conditions of the agreement, incurs no direct cost of capital but implies dilution of the company’s existing equity interest, which may or may not be favorable.
If a new investor receives a 10% ownership in the firm, a shareholder who previously owned 40% will now hold 36% (i.e. 90% of 40%). Based on the value of great service as measured by total asset and liability, which are around $7,000,000 and $4,000,000, respectively, an investor bringing in $500,000 would most certainly want a significant stake in the firm.
The implication of this option is compatibility issues. Unless the investor is well
known or has a proven record of Non-interference, it may not be so easy because the
company and the investor may not share the same vision or even same strategy to achieving
shared vision.
Option 3: Private Buy-out
A private buyout happens when the transaction directly funds the company’s owner (Slee, 2011). Some of the company’s proprietors are considering retiring and exploring other hobbies. When the company’s owners sell it, they will no longer be accountable for its management. Because the sale of shares is private from one person to another and the firm does not profit immediately, it has no effect on financial results.
However, this option means selling whole ownership of the firm, maybe with the understanding that you would continue to manage and run the business. There are several reasons why business owners decide to sell their company. After putting your money, time, and energy into building and growing your business, the moment will come when selling it may be the wisest option you can make. The effect of this solution is that Exceptional Grading Company’s current shareholders will have no ownership in the new firm, resulting in zero equity in its capital structure.
Option 4: Issuing Corporate Bonds
A sort of debt security that is issued by a firm and sold to investors is known as public debt (Slee, 2011). Payment stops when the bond matures and the initial investment is repaid. The consequence of releasing public debt is that it affects the income statement via the interest expense and amortization expense categories.
On the balance sheet, cash accounts are debited, whereas bond payable accounts are credited (Choudhry, 2004). The capital structure will be changed, with debt increasing by $500,000 and the cost of capital decreasing.
The effect on capital structure is that the interest payment (the coupon) is part of the return that bondholders gain for lending their funds to the issuer, which raises the cost of capital. The implication of pursuing this choice is that it may cost the owners their firm if they fail to meet the bond’s coupon payment and other obligations (Fernando, 2022).
If Exceptional Grading Company wishes to sell bonds to the public, they must do it over a three-year period with low coupon rates because their present debt already accounts for more than 70% of their entire liability, and adding to this existing load may not be in their best interests.
Option 5: Issuing Public Common Stock
This typically entails taking the firm public. While this option relieves the exceptional grading service of any financial obligation, it results in a diminution of equity and, by extension, capital structure. The issuance of public common stock will have an impact on the balance sheet since the owner’s equity will grow by $500,000 and the cash will increase by the same amount (Wright, 2020). The equity-debt mix will be changed, and the firm will be equity-financed. Therefore, the cost of equity is anticipated to rise dramatically.
The cost of capital is the same as the implicit cost of equity. Aside from a fair loss of control, going public entails the firm being forced to disclose financial, accounting, tax, and other business information. It may have to publicly share secrets and business processes that might aid competitors during these disclosures. If the shareholders do not object to the foregoing consequences, Thus, I believe this is the greatest option for raising the cash needed for the firm’s organic development and expansion.
References
Choudhry, M. (2004). Corporate Bonds and Structured Financial Products. Elsevier.
Nesbitt, S. L. (2019). Private Debt: Opportunities in Corporate Direct Lending. Wiley.
Slee, R. T. (2011). Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests. John Wiley & Sons.
The Investopedia Team. (2021, May 31). The impact of financing. Investopedia. Retrieved December 25, 2022, from https://www.investopedia.com/ask/answers/051315/how-does-equity-financing-affect-companys-financials-compared-effects-debt-financing.asp
Wright, T. C. (2020). How to Adjust an Income Statement for an Equity Issuance. Chron.
Retrieved December 25, 2022, from https://smallbusiness.chron.com/adjust-income-statement-equity-issuance71298.html
Fernando, J. (2022, July 1). Bond: Financial meaning with examples and how they are priced. Investopedia. Retrieved December 25, 2022, from https://www.investopedia.com/terms/b/bond.asp
Volker, M. (1997). Business basics — Equity: Dividing the pie. Simon Fraser University. https://www.sfu.ca/~mvolker/biz/equity.htm
Note:
This article is written based on University of The People Financial Management (BUS 5111) written assignment by Fristy Tania in November 2022
