Assignment Exploring Financing options: Debt versus Equity

Darrell Homer wants to expand his business. Revenues have been a bit erratic over the last few years, but Darrell believes that COVID presents an opportunity to expand since some of his competitors have gone out of business. Darrell can either borrow money or sell additional equity. Currently Darrell owns 55% of the business and investors own the remainder. Complete the information below for two different scenarios and then answer the questions on the next page. In Scenario A, Darrells company borrows an additional $200,000 at 6% interest. In Scenario B, the company sells (company raises money) an additional $200,000 in common stock, for which the new investors will receive 10% ownership in the business. Assume that revenues and expenses (other than those related to debt) do not change. (Money raised from either debt or equity will be reinvested in the business, but you do not have to show the increase in other assets or any potential increase in revenues).

Abbreviated Balance Sheet Information
	Currently	Scenario A More Debt	Scenario B More Equity
Liabilities (Debt)	$ 275,000
Stockholders Equity	$1,750,000
Abbreviated Income Statement
Revenues	$1,425,000
Expenses (before interest and taxes)	860,000
Inc. before interest and taxes	565,000
Interest expense (at 6% on total debt)	16,500
PreTax Income	548,500
Taxes (rate of 35%)	191,975
Net Income	$ 356,525
ROE	.239
Debt to Equity Ratio	.157

• Which option would you advise Darrell to take (more debt or sell equity) and why?

• If Darrell is successful in selling the equity, what does that suggest is the total value of the business?

• What percentage ownership will Darrell have if the company issues more shares for the 10% stake in the business?

• If Darrell borrows the money what is the real cost (hint: not 3%, the interest rate. Because of the tax deductibility of the interest, the tax savings is netted from the interest cost.)