Question

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:

Questions:

•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.

Answer 1

1. Debt financing is tax deductible, means that the cost of debt financing (interest) is pre tax item and it helps an organization to save tax by charging its cost as tax deductible. Therefore effective cost of debt reduced by tax % and makes it more cost effective.

2. WACC = 10%*(1-0.35)*0.6 + 15%*0.4 => 9.9%

3. ROI is 8 % while WACC is 9.9%, therefore we need to increase debt (as debt cost of financing is 6.5% which is less than our required rate or return) component to achieve our required rate of return.

4. As an angel investor using more debt protects it if the failure of business happens by providing them the first claim on assets in case of bankruptcy. While on the other hand if the business goes successful then in that case they will not be able to participate in upside. Therefore, it is recommended that they should invest through convertible preferred or convertible debt, which allows angels to have claim on asset before equityholders and as convertible instrument it retains the upside as well.

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