Question

Over the past 5 years Truman Incorporated has been maintaining its total debt ratio in the range of 60%-70%. (Support your answers with a framework of any capital structure theories we discussed in class):

a) Give at least three reasons why Truman might be using debt financing, instead of using equity financing only?

b) Truman Inc. has been maintaining debt levels in a range of 60%-70% over the past 5 years. Why is Truman not using equity only? Alternatively, why does not Truman increase its leverage beyond 70%, for example?

c) As an external consultant to Truman – what would you recommend to Truman’s CEO as “best practices” in their project financing needs for the next 4-5 years? (You may bullet-point you suggestions/ideas. List at least 5 suggestions).

Answer 1

Let us understand what is debt ratio. Total debt ratio formula is given by total liabilities/total assets. It means what portion of assets are owed to creditors.

3 major reasons for debt financing over equity financing can be:

a) Debt doesnt dilute the ownership interest in the company where equity infusion would dilute

b) Interest on debt is tax deductible. This overall lowers the cost to the company.

c) No direct claim on profit of the business. The lender will get only the repayment agreed money and not the claim on profits of the company.

The reason for maintaining only 60-70% of debt level because higher the Leverage, the higher the risk for the company. Also, any additional to the existing debt would be costly to the company because the chances of company repaying would become difficult hence interest bearing cost would become more.

As an external consultant, my suggestions would be:

a) look at current shareholding by promoters. If it is high, we can explore for any equity financing options

b) perform risk analysis and review the financing structure and also project long term cashflow projections.

c) Enter into long term agreement such as operation and maintenance agreement

d) perform legal, technical and insurance due diligence

e) Maintain the debt to equity ratio to the desired level by making considerable changes to the financing structure