Question

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:

• 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

=> It is given that entrepreneur hopes to financed using 60% debt and 40% equity, it is also given that cost of equity is 15% and cost of debt is 10%, required return on investment is given as 8% and corporate tax is 35%

=> Before moving into the checklist question, we will see how the WACC will be when we structure it using 60% debt and 40% equity.

=> The formula to calculate WACC is:

, where is weightage of equity, is weightage of debt, is cost of equity, is cost of debt and t is the tax rate.

=> Since we know all the values substituting into the formula:

=> Therefore WACC will be 9.9% if we finance it with 60% debt and 40% equity

=> Now we will move to the first checklist

=> We already know WACC (9.9%) when we finance using 60% debt and 40% and the required rate of (ROI) is 8%. In order to get a positive ROI we have to restructure the finance in such a way that the WACC is less that 8%. We can do that by reducing the weightage of our equity financing and increasing the weightage of debt financing.

=> We will see at what value of weightage of debt and equity financing we will get a WACC less than 8%:

. take this as equation 1

we also know that

, substitute this value in equation 1 we will get:

Solving the equation we will get > 82.35% , that means we will start to get positive ROI when weightage of debt is above 82.35%(when weightage of debt financing is 82.35%, weightage of equity financing will be 17.65%)

=> Now we can move to the second checklist question

=> Adding more and more weightage to debt will help us reduce the WACC thus helps in improving our Return on Investment. WACC should be lower than our required return on investment to get a positive cashflow also interest expense on debt financing is tax deductible. debt financing is also having its own disadvantage like it is a obligation to pays back the entire debt along with interest even if our business is not generating any positive cashflow whereas there is no obligation in equity financing. In case of bankruptcy, after selling all the assets we have to payback the debt holders first and whatever remaining after paying back to debt holders will be paid back to equity holders.