Question

Problem 13.8 a local entrepreneur is looking for investors any new company that will develop mobile apps for behavioral health. The company requires a $15 million in start up funds. it can be capitalized with 100% of equity financing or with 30% debt and 70% equity. Expected operating income is $3 million and the company will pay taxes at a rate of 40%. Debt financing would bear and interest rate of 7%.

a. What would be the firm’s net income, total dollar return to investors, and ROE with 100% equity financing

b. What would be the firm’s net income, total dollar return to investors, and ROE with 30% debt financing and 70% Equity financing.

c. What factors should be investors consider when deciding on the appropriate capital structure?

Answer 1

Answer to (c)

100% investment in equity is a risky affair. With a high volatile market a company can loose out a lot in a single day. So it is basically a high risk high gain can kind of structure.

Where as with debt financing, the return could be low, but generally consistent and less risky.

So, if the startup is looking for rapid growth in short span of time, it should concentrate more on equity financing. On the other hand, for a slow and steady growth debt financing is more suitable. Basically a combination of both equity and debt is preferred by most companies and weighted average cost of capital model is used to determine the weightage of each investment.