Question

Scenario: You are an Angel Investor who has been approached by an entrepreneur to assess an investment opportunity.

An entrepreneur asks for $100,000 to purchase a diagnostic machine for a healthcare facility. The entrepreneur hopes to maintain as much equity in the company, yet the Angel Investor requires the transaction to be financed with 60% debt and 40% equity.

As the Angel Investor, you assign a cost of equity of 16% and a cost of debt at 9%. Based on Year 1 sales projections the entrepreneur assures you, the Angel Investor, a Return on Investment (ROI) of 9%; conceptually this will cover the first year’s pretax cost of debt and allow for planned equity growth and a refinancing model for Year 2. You will use an After Tax Weighted Average Cost of Capital (AT- WACC) model which includes the after tax cost of debt and proportionate costs of Debt vs. Equity. A 35% marginal tax rate is applied.

Address the following checklist items:

Checklist:

• 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 a financial restructuring AT- WACC (given changes to proportions of % Debt vs. % Equity financing) that would create a positive ROI.
• Explain why you as the Angel Investor would require more or less debt vs. equity financing. Be sure to note the role of the Unified Commercial Code-1 (UCC-1) document in this transaction and the order of claim on assets in times of a bankruptcy.

Answer 1

In order to reduce the AT-WACC, they need to increase the proportion of debt component in their project, say 70 percent of debt and 30 percent of equity. In this case, AT-WACC would be less than the expected ROI.
AT-WACC = 0.7*5.85 + 0.3*16
=4.095 + 4.8
= 8.895 percent

Every rational investor should maintain an optimal debt-equity ratio. But in this case, increasing debt would result in rise in bankruptcy costs for the company. According to MM approach, present value of interest tax shield should exceed present value of bankruptcy cost. UCG-1 document establishes supremacy of creditors claims over debtors which, in this case, should be duly kept in mind.

In my opinion as an Angel investor, one should not invest in this opportunity.