Question

Assessment: The Angel Investor

This Competency Assessment assesses the following outcome:

MT480M6: Incorporate the combined attributes of debt and equity given a cost of capital model.

The concept of after-tax Weighted Average Cost of Capital (WACC) is a common issue when studying finance at all levels. The impact of taxes, applicable to most forms of financing is a key component of studies in the field of finance. The Assessment questions will present the opportunity to assess and build upon your knowledge of and ability to calculate the after-tax WACC and the cost of debt and equity.

Read the fictional scenario and respond to the checklist items in this written Assessment.

Scenario: As an Angel Investor you have been asked to assess an entrepreneur’s product and financing options. In your role as an Angel Investor you focus on one year at a time. The entrepreneur asks for $100,000 immediately to purchase a diagnostic machine for a healthcare facility. The entrepreneur hopes to be financed with 60 percent debt and 40 percent equity. As the entrepreneurs’ venture capital partner, you assign a cost of equity of 15% and a cost of debt at 10%. You require a Return on Investment (ROI) of 8%. You are using an After Tax Weighted Average Cost of Capital (AT- WACC) model. A 35% marginal tax rate is applied Address the following checklist items:

Checklist:

• Explain the tax benefits of debt financing.

• Calculate the AT- WACC with a 60% debt and 40% equity financing structure.

• Apply the calculated AT-WACC to explain why this is or is not a viable investment for you as the Angel Investor.

• Explain what the entrepreneur’s financial restructuring AT- WACC (% Debt and % Equity) need to be in order to create a positive ROI.

• Explain why you as the Angel Investor would require more or less debt versus equity financing. Be sure to note the nature of the claims on assets in times of a bankruptcy.

• Submit your response in a minimum of a 2-page APA formatted Microsoft^® Word^® document to the Dropbox with additional title and references pages.

Access the rubric

Minimum Submission Requirements

• Address all the checklist items.

• Include a strong thesis statement, introduction, and conclusion. The main points of the response should be developed and explained clearly in the denial letter with appropriate financial and accounting terminology.

• Your content should follow proper APA citation style. For assistance with APA formatting, go to the Writing Resources accessed through the Academic Success Center within the Academic Tools area of the course. APA formatting dictates that your paper includes a cover sheet (i.e., title page), the paper is double spaced, in Times New Roman 12-point font, with correct citations, uses Standard English with no spelling or punctuation errors.

Answer 1

Debt-Financing

Debt-Financing is one of the methods of financing your capital structure. Debt-financing refers to use of debt in your capital structure.

Benefits: Debt-financing helps to obtain funds for capital structuring as well as provides tax shield at the same time. The compensation that is paid to obtain debt from debt providers is called 'Interest'. This interest is tax deductible, i.e. interest is allowed as an expense while computing profits and hence allows us to enjoy tax shield.

In the given problem, the entrepreneur requires $1,00,000 to be financed with 60% debt and 40% equity.
Cost of equity (Ke)= 15%
Pre-tax cost of debt (Kd)= 10%
Marginal Tax rate is 35%
Hence, Post-tax Kd= 10 * (1-0.35) =  6.5%
Now, WACC= [Weight of debt (Wd) * Cost of debt (Kd)] + [Weight of equity (We) * Cost of equity (Ke)]
= (60% * 6.5) + (40% * 15)
= 3.90% + 6%
= 9.90%

Now, in the given case, we can see that the expected rate of return on investment (ROI) is 8% only. Since, the cost of financing i.e. 9.90% is greater than ROI, this is not a viable investment.

In order to have a positive ROI in excess of 8%, WACC should be less than 8%. Let us assume the weight of debt (Wd) to be X% and weight of equity (We) to be (100-X)%.
Now, WACC= (Wd * Kd) + (We * Ke)
8 = (X% * 6.5) + [(100-X)%* 15]
8 = 6.5X + 15- 15X
8 = -8.5X + 15
8-15 = -8.5X
  -7 = -8.5X
Therefore, X= 82.35% & (100-X)= 17.65%
Hence, we can conclude that debt proportion should be more than 82.35% and Equity proportion should be less than 17.65% in order for the investment to be viable.

We need more of debt financing than equity financing in order  for the investment to be viable. In the given case, the expected ROI is 8% and in order to have positive ROI than WACC, the WACC should always be less than 8%. This is only possible if the debt financing is more than 82.35% and equity financing is less than 17.35% due to high cost of equity. Debt is cheaper than equity and moreover tax-deductible. Hence, debt financing should be more. We understand that in case of bankruptcy, debtholders are given more preferance than equity holders. The debtholders would have preferential rights over the assets before the equityholders. However, the investment would not be viable if equity proportion is more than debt due to high cost of equity.