Question

Since the great recession of 2008, the Federal Reserve has had an aggressive policy of stimulus primarily with very low interest rates. This week we discuss cost of capital and project valuation. Given the even lower interest rates to combat the Coronavirus and its economic impact, what would the key considerations be for determining the method of financing for a major project. Assume that you are financing a major business acquisition (around $500-600 million). Use all materials that you have studied (i.e. issuing stock, debt financing, etc). Be sure to justify your answer with research (with citations).

Answer 1

Aggressive policy of of providing stimulus in order to revive the economy is one of the major tools of Federal Reserve. It lowers the interest rate to almost negligible extent and it also provides bailout packages and additional stimulus to revive the demand in the overall economy so that economy could be back to growth.

Key consideration for determining the the method of Financing for a major project would be-

A. Issuing stock in such times when interest rates are highly low is not generally preferable because it will lead to dilution of control in such times when there is a crisis like situation and the business would not want to lose its control on its overall management.

B. Debt financing is lucrative from a certain prospect that it will have to pay a lower rate of interest on the overall debt which has been taken, so the debt financing would be very lucrative option at such point of time, when there is an economic crisis and negligible interest rate.

Debt payment also has an additional element of interest rate tax shield associated with it, so the interest payment on debt financing are tax deductible in nature and hence it would be more preferable by the company.

The only problem with debt payment, is that if the return on capital of the company is very low in comparison to the overall cost of debt, then it would not be able to finance it interest cost and it would be leading into bankruptcy cost.

There are another methods of Financing which can be simultaneously used by the company such as retained earnings and hybrid method of financing which will include both debt capital and equity capital in order to minimise the overall risk of the project and maximize the overall return of the project.

So I would look to always balance in order to have the debt capital, because the interest tax shield would always be traded off with the cost of financial distress associated with debt repayments.