Recommendations For Financial Options For Competent Capital

Recommendations for financial options Competent capital guidelines rely on pecking theory which states that in choosing financing options, the given order is followed ; internal financing- debt- equity

In this analytical discussion, the focus is on identifying the most appropriate financial strategy for Thompkins Auto Group’s upcoming $2 million investment. The company is considering three primary options: taking a secured bank loan, issuing new shares, or selling dealership subprime notes receivable. Based on the principles of pecking order theory, which suggests firms prefer internal financing first, followed by debt, and then equity, this report evaluates each option’s merits and drawbacks within the specific context of Thompkins Auto Group’s circumstances.

Currently, Thompkins Auto Group relies primarily on internal financing and some debt, which may threaten its long-term stability if not managed prudently. The upcoming investment involves extensive upgrades—half allocated to building improvements and the rest to equipment—aimed at enhancing the company’s market position. The annual revenue of approximately $1.5 million indicates a modest but steady income stream that can potentially support new debt obligations if carefully managed. The analysis proceeds by examining the three primary financial options and recommending the most viable strategy based on risk, cost, and strategic alignment.

Analysis of Financial Options

Secured Bank Loan

The most suitable financial option identified for Thompkins Auto Group is securing a bank loan. This involves borrowing the entire $2 million against collateral, specifically dealership assets valued at approximately $3 million, with a repayment period of five years at an interest rate of 4%. Secured loans tend to attract lower interest rates due to collateral backing, minimizing the financial cost over the loan period. Additionally, interest payments on such loans are tax-deductible, further reducing the effective cost for the company. Given the company's existing revenue base, the manageable interest rate, and collateral support, this option aligns well with the company’s strategic and financial realities.

Advantages of a Secured Loan

• Lower interest rates compared to unsecured loans, reducing overall borrowing costs.
• Retention of ownership and control, as no equity needs to be surrendered.
• Predictable repayment schedules, aiding in effective cash flow management.
• Collateral provides security to lenders, making approval more feasible despite moderate credit history.

While the company's tax rate of 35% impacts after-tax income, the tax shield resulting from interest deductions significantly improves the net cost of borrowing. The loan would facilitate necessary improvements, likely boosting revenue and cash flow, thus ensuring repayment capability within the five-year term.

Disadvantages of a Secured Loan

• Financial risk associated with over-leverage if projects do not generate expected returns.
• Potential strain on cash flows during repayment periods.
• Collateral risk if the company faces unforeseen financial difficulties.

Despite these risks, the secured loan provides a balanced approach that aligns with the company’s current financial capacity and growth plans, leveraging collateral to secure favorable terms.

Issuance of New Shares

Issuing new equity shares to finance the investment is less advisable in the current economic climate. The limited ownership stake (around 20%) among existing family and stakeholders diminishes the attractiveness of diluting ownership further. Moreover, declining local economic conditions, reflected in reduced share prices and investor reticence, would lead to minimal capital inflow if shares were sold. Additionally, shareholders would expect dividends of approximately 15%, which could dwindle retained earnings and impact reinvestment capacity. This dilutive effect and uncertain market conditions make equity issuance a poor short-term financing choice.

Selling Dealership Subprime Notes Receivable

The third option involves selling subprime notes at an 18% interest rate, receiving approximately 85% of face value. This option provides immediate liquidity but entails cost and risk considerations. The high interest rate and the potential for fluctuating interest expenses due to the adjustable rate nature of subprime lending increase long-term costs. Moreover, the sale might result in an interest loss and reduced future cash inflows. Since this method is more suitable for long-term funding and involves higher risk, it is less favorable for immediate upgrade needs.

Cost of Capital Considerations

Estimating the cost of capital is crucial for decision-making. The aggregate capital includes total debt, preference shares, and market value of equity. Preference shares, if issued, would have a cost equivalent to dividends on preferred stock, and debt entails coupon payments according to the agreed rate. For Thompkins Auto Group, the weighted average cost of capital (WACC) guides investment evaluations and helps compare the benefits of debt versus equity. A lower WACC associated with secured loans supports their selection due to cost-effective financing and risk mitigation.

Conclusion and Recommendation

Given the analysis, the recommended financial strategy for Thompkins Auto Group is to pursue a secured bank loan. This approach offers a low-interest, collateral-backed source of funds that aligns with the company’s operational capacity and growth ambitions. It preserves ownership equity, reduces overall financing costs, and provides flexibility to manage repayment in context of expected increases in revenue from improvements. The other options—issuing shares or selling subprime notes—pose higher risks, costs, and strategic drawbacks under current economic conditions.

In summary, securing a debt financing option is the most prudent move for Thompkins Auto Group at this juncture. It balances risk and cost while enabling the company to execute its growth strategies without relinquishing control or exposing itself to undue financial strain.

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