Question

The Government of Ghana in an attempt to stimulate the Ghanaian economy after the COVID 19 pandemic has set aside GH¢600 million as a stimulus package for businesses. These stimulus packages are to be in the form of soft loans for businesses. However, some believe that these loans must be extended to firms in industries that are worst hit by the pandemic. As the Finance Director of your company, you have been tasked to present a proposal to the Board of Directors of your company for consideration. Your proposal must address the following;

1. The negative impact of the COVID 19 pandemic on the operations of your firm, justifying why your firm needs such a stimulus package? Your arguments should be situated within the industry within which you operate.
2. With your understanding of lessons on capital structure, which other four (4) factors should your firm consider before choosing this source of debt finance?
3. Discuss four (4) risks that your company is likely to be exposed to if it goes ahead with this source of debt finance.
4. Explain how this decision will affect the return to the equity holders or shareholders of your company following the arguments of M&M proposition 2.

Answer 1

Factors to consider when choosing a source of finance

• The amount required. ...
• Type of expenditure/Purpose for which the capital is required. ...
• The length of time for which the money is required. ...
• The size, status and ability of the business to borrow. ...
• The business's current level of gearing. ...
• The business's level of reserves and profits. ...
• The cost of the source of finance.

As a small-business owner, you essentially have two ways to raise business capital if you don't have the money yourself to start or grow. You can sell shares in the company to investors, though you give up some ownership and control this way. The other option is borrow money from the bank. With debt financing, you retain ownership and control, but other risks are present.

Over-Leveraging

Debt capital is often referred to as leverage, because you borrow against future earnings of the business. When you take on too much debt, it becomes difficult to keep up with ongoing business expenses plus debt repayments. A company that generates $10,000 a month in profit, for instance, would struggle to maintain and grow if it had to allocate $5,000 of that profit toward monthly debt commitments. Debt financing can become a downward spiral, as some businesses look to take on new loans to keep up with existing obligations.

Future Financing Limitations

If you elect to take on significant debt financing at the start of business, you may limit your future borrowing potential. Lenders usually look over company financial statements to compare debt obligations to assets and earnings. If you already have sizable debt commitments, the bank may find it too risky to loan you more money. This puts you in a situation where you likely have to issue stock to raise capital.

Slumps and Collateral

A key risk of borrowing now and leveraging future cash flow is that sales could slump at some point, making it difficult to make payments. This can lead to missed payments, late fees and negative hits on your credit score. Additionally, some business loans are used to pay for buildings, cars and other physical assets. On property loans, the asset normally serves as collateral. Thus, if you fail to keep up with payments, you risk property seizure by the bank.

Lack of Reinvestment

If debt financing challenges your ability to keep up with current expenses and commitments, it really impedes reinvesting earnings into business expansion. Over time, companies grow through research, product or service development, addition of business locations and marketing and promotion to attract more customers. High debt leverage stifles your ability to engage in any of these activities. Often, companies that don't grow fall behind more-aggressive competitors and eventually experience customer and profit erosion.

Funding a company through debt, rather than selling company stock to attract capital, avoids diluting the stockholders' percentage ownership of the company. However, if there is a large capital position supplied by stockholder investment, the company has a better credit profile. If shareholders assume risk by funding the company with their capital, the company is likely to be more conservatively operated. If the firm finances itself through debt, the creditors shoulder the risk. However, if the debt results in increased earnings, the return on shareholder investment is exponential.

Return on Assets

To calculate return on assets, first find the profit margin by dividing net income by revenues. Then, calculate asset turnover by dividing total revenues by total assets. Finally, multiply profit margin by asset turnover to find ROA. These numbers can be found on the balance sheet and the income statement.

Debt and ROA

Increased debt has the potential to lower revenues as more money is spent servicing that debt. If it is spent to increase production and production leads to significantly increased revenues, increased debt may increase ROA. That depends on whether the debt burden is so costly it cuts into net income. If revenues rise as a result of debt financing of production, but net income falls due to increased expense, ROA declines.

Return on Equity

Return on equity is calculated by dividing annual earnings by average shareholder equity over the year. Annual earnings are listed in a company's annual report. Shareholder equity is listed in the balance sheet. In establishing a true picture of shareholder equity, check the company's quarterly statements to see if shareholder equity has fluctuated during the year.

Debt and ROE

Increased debt increases the leverage factor in a company. During normal or boom times, leverage results in exponential profit returns. During recessions, leverage can result in exponential losses, as well. A large debt burden carries risk because of the reaction of leverage to the prevailing economic conditions. Increased debt favors ROE during boom times but hurts ROE during recessions.