How to Advise a Company On Its Best Financing Option The Question - - PowerPoint PPT Presentation

Debt vs. Equity Analysis: How to Advise a Company On Its Best Financing Option

The Question…

“I have an upcoming IB case study where I’ll have 60 minutes to analyze a company’s financial statements and recommend debt or equity.” “How I should do this? What analysis or qualitative considerations should I include?”

The Short Answer on Debt vs. Equity

• Cost: All else being equal, companies want the cheapest possible

financing

• Debt: Tends to be cheaper than Equity because interest paid on

Debt is tax-deductible, and lenders’ expected returns are lower than those of equity investors (shareholders)

• BUT: There are also constraints and limitations on Debt – the

company might not be able to exceed a certain Debt / EBITDA,

• r it might have to keep its EBITDA / Interest above a certain level
• So: You test these constraints first and proceed accordingly

The Short Answer on Debt vs. Equity

• Step 1: Create different scenarios for the company – can be simple,

such as lower revenue growth and margins in the Downside case

• Step 2: “Stress test” the company and see if it can meet the

required credit stats and ratios in the Downside cases

• Step 3: If not, try alternative Debt structures (e.g., no principal

repayments, but higher interest rates) and see if they work

• Step 4: If not, consider using Equity for some or all of the

company’s financing needs

Example: Central Japan Railway Case Study

• PROBLEM: Company needs to raise ¥1.6 trillion ($16 billion USD)
• f capital to finance a new line
• Option #1: Additional Equity funding (would represent 43% of its

current Market Cap)

• Option #2: Term Loans with 10-year maturities, 5% amortization,

~4% interest, 50% cash flow sweep, and maintenance covenants

• Option #3: Subordinated Notes with 10-year maturities, no

amortization, ~8% interest rates, no early repayments, and only a Debt Service Coverage Ratio (DSCR) covenant

Example: Central Japan Railway Case Study

• PROCESS: Start with the Term Loans (Option #2) since they’re the

cheapest form of financing (~4% interest rates)

• Evaluate how the required credit stats and ratios look in different

cases, focusing on the more pessimistic ones – how lenders think!

• PROBLEM: It would be almost impossible for the company to

comply with the minimum DSCR covenant, even in the Base case, and it looks far worse in the Downside cases

• Next Step: Try the Subordinated Notes instead – lack of principal

repayment will make it easier to comply with the DSCR

Example: Central Japan Railway Case Study

• Results: DSCR numbers look a bit better in this case, but there

were still issues in the Downside and Extreme Downside cases

• One Solution: A different form of Debt that uses “sculpting,” as in

Project Finance or Infrastructure, to vary the interest and principal repayments over time (ramp up as project is completed)

• But: Here, we have only three options, so we must use more

Equity – try 25% or 50% Equity to start with

• Simulate By: Setting the EBITDA multiple for the Debt to 1.0x or

1.5x instead (so the remaining 1.0x or 0.5x is Equity)

Example: Central Japan Railway Case Study

• Results: 50% / 50% Subordinated Notes / Equity is better if we

strongly believe in the Extreme Downside case; 75% / 25% is better if the normal Downside case is more plausible

• Qualitative Factors: You can then use these to back up your

recommendations based on the numbers

• Point #1: Extremely high EBITDA margins, low revenue growth,

and stable cash flows due to near-monopoly – ideal for Debt

• Point #2: Limited downside risk in the next 5-10 years; population

decline in Japan is more of a concern over several decades

Recap and Summary

• Companies: Want the cheapest funding possible for expansion

projects, acquisitions, etc. – which usually means Debt

• But: But Debt also has constraints, and you have to see if the

company can comply with those constraints in Downside cases

• Yes: Easy, use the proposed Debt package!
• No: Try other options for Debt, and add Equity if necessary
• And: Use the qualitative factors to support your recommendation