Running Head Thompkins Auto Group 1 Thompkins Auto Group Cap

Running Head Thompkins Auto Group 1thompkins Auto Group Capital

Assess the best financing option for Thompkins Auto Group’s $2,000,000 capital improvements, considering debt financing, equity issuance, or sale of receivables. Include analysis of cost of capital, impact on future cash flows, tax implications, and risk. Provide a reasoned recommendation supported by quantitative evidence and relevant financial principles.

Paper For Above instruction

Introduction

Thompkins Auto Group, a thriving automobile dealership in North Central Texas, faced a pivotal decision in 2020: how to finance a $2 million upgrade to its facilities and equipment. With annual sales averaging $50 million and profits above industry average at 3%, the dealership’s leadership recognized that sustaining growth and maintaining high customer satisfaction required significant investment. The dilemma lay in choosing the most effective and financially prudent financing approach among debt financing, equity issuance, or the sale of receivables. This paper analyzes these options, evaluates their implications on the company’s cost of capital and cash flows, and recommends the most suitable approach based on quantitative evidence and financial theory.

Background and Strategic Context

Thompkins Auto Group’s strategic focus has always centered on customer satisfaction, achieved through excellent service and strong relationships, supported by well-trained staff and quality equipment. To uphold these standards amidst technological and operational changes, upgrading the service department’s machinery and renovating the facility was deemed imperative. The estimated cost for facility improvements was $1 million, and for shop equipment, $1 million, totaling a $2 million investment. The dealership’s financial structure and economic environment, characterized by reliance on the oil industry which was experiencing volatility, influenced the decision-making process regarding financing options.

Financing Alternatives and Analysis

Debt Financing: Bank Loans

Two bank loan options were considered: unsecured and secured loans. The unsecured loan offered a five-year term with a 6% interest rate, requiring a $200,000 deposit earning 1%. The secured loan, backed by the dealership’s $3 million notes receivable, also had a five-year duration but at a lower 4% interest rate. The tax implications of each option, considering Thompkins’ 35% corporate tax rate, were significant. Debt financing generally lowers the weighted average cost of capital (WACC), especially with the secured loan’s favorable interest rate, but increases leverage risk, particularly given the dealership’s reliance on the volatile oil sector. Notably, the secured loan’s collateralized nature could reduce borrowing costs but could also impose liquidity constraints if the notes’ value declined.

Equity Financing: Issuance of New Shares

Issuing new stock to raise $2 million would dilute existing ownership, especially affecting Jerry’s majority stake. The cost of issuing new equity was assumed minimal; however, equity issuance generally increases the firm’s cost of capital if the cost of equity exceeds debt, which is often the case in riskier environments. The target capital structure set at 30% equity and 70% debt implied that the company’s WACC might rise if new equity were issued at current market valuations. The expected return on equity, based on the Capital Asset Pricing Model (CAPM), considering a beta of 1.4 (similar to CarMax) and current risk-free rates, was estimated to be around 12%.

Sale of Notes Receivable

The dealership’s $3 million portfolio of subprime auto loans carried an 18% interest rate but faced high risk, with previous write-offs averaging 15-18%. Selling these notes at a discount could generate immediate cash; selling without recourse at 65% of face value or with recourse at 85% were considered. Selling without recourse would realize less cash upfront but limit future liabilities, whereas selling with recourse increased cash inflow but transferred the default risk to the buyer. The decision’s impact on cash flow was substantial; selling at a discount would lead to a significant reduction in future cash flows but might be advantageous if immediate liquidity was prioritized.

Cost of Capital and Financial Impact Analysis

The cost of capital for each financing method was evaluated as follows:

• Unsecured Bank Loan: 6% interest, tax shield benefit reduces effective cost to approximately 3.9% after tax (interest expense deductible at 35%). However, the higher interest rate reflects a greater risk premium due to the unsecured nature.
• Secured Bank Loan: 4% interest, resulting in an effective after-tax cost of about 2.6%, making it the most financially efficient debt option. The collateralized loan presents lower risk and cost but could involve restrictions based on collateral value fluctuations.
• Equity Issuance: Using the CAPM, the cost of equity was estimated at approximately 12%, considering the risk-free rate (.63%) plus Beta (1.4) times market risk premium (assumed at 7-8%). The minimal issuance costs do not significantly alter this estimate, but dilution effects and impact on earnings per share are notable.
• Sale of Receivables: Discounted at 65%-85%, representing a trade-off between immediate cash inflows and future revenue streams. The effective cost of converting receivables to cash could be viewed as the discount rate, roughly 35-45%, which can be contrasted with the other financing costs to assess overall efficiency.

Recommendation and Rationale

Analyzing the cost of capital and cash flow impacts, the secured bank loan emerges as the most financially advantageous option. Its lower effective interest rate (about 2.6%) and tax benefits favor debt financing, aligning with the dealership’s target capital structure and risk appetite. The collateralized nature minimizes borrowing costs without exposing the company to excessive leverage risk that could destabilize operations, especially given industry volatility.

Issuance of new equity, while preserving cash and avoiding debt, would dilute ownership and potentially reduce earnings per share, which stakeholders might oppose despite the minimal issuance costs. Selling the notes receivable produces immediate liquidity but at a substantial discount, diminishing future cash flows and profitability. Moreover, the risk of higher default rates during economic downturns makes this option less resilient.

Therefore, the optimal strategy involves securing a bank loan with collateralized notes, balancing low-cost capital and risk management. This approach supports the dealership’s growth objectives while maintaining financial flexibility and stability in uncertain economic conditions.

Conclusion

In conclusion, Thompkins Auto Group should pursue a secured bank loan for its $2 million capital upgrade. This method offers the lowest effective cost, favorable tax treatment, and controlled risk exposure necessary for sustaining operations during economic fluctuations. Accompanying this with prudent management of receivables and continuous evaluation of market conditions will ensure that the dealership remains competitive and financially healthy.

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