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The company you work for is considering building a new warehouse and manufacturing facility. The cost of the new buildings will be $6.9 million. Your manager wants you to decide how the company should finance the new building. If you decide to finance the construction with debt, then list the type of debt you would encourage the company to undertake and what the anticipated cost of that debt would be. Incorporate current commercial interest rates.

The company currently has a double AA credit rating. List the advantages and disadvantages of securing a loan from your local financial institution. Also consider the advantages and disadvantages of securing your loan from an angel investor. If you decide to finance the construction with equity, decide how much equity you will need to surrender in order to acquire the needed funds. Your company currently has 4 million shares outstanding and carries an estimated value of $24 per share. Write a 2-3 page paper that thoroughly addresses the above issues.

Paper For Above instruction

Introduction

The decision to finance a substantial capital investment such as building a new warehouse and manufacturing facility requires careful consideration of various funding options. The primary choices include debt financing and equity financing, each with its advantages, disadvantages, and implications for the company's financial health. This paper examines the optimal financing strategy for a $6.9 million project, considering current commercial interest rates, the company's credit rating, and the implications of leveraging either debt or equity.

Debt Financing Options and Cost Analysis

Given the company's double AA credit rating, it is prudent to consider debt options that balance low cost with manageable risk. Currently, the prevailing commercial interest rates for investment-grade corporations hover around 3.5% to 4.5% for long-term bonds (Federal Reserve, 2023). For a project of this magnitude, issuing corporate bonds or securing bank loans are the most feasible debt options.

Corporate Bonds: The company could issue a bond with a maturity comparable to the project’s lifespan, say 10-20 years. With an AA rating, the company could expect to pay interest rates close to 3.75%. The total annual interest expense for a $6.9 million bond at this rate would be approximately $258,750, calculated as 3.75% of $6.9 million (Investopedia, 2023).

Bank Loans: Alternatively, securing a bank loan could provide more flexibility, potentially with a variable interest rate around 3.5% to 4%. Given the company's credit standing, a bank might charge a rate of approximately 3.8%, with similar repayment terms.

The advantages of debt financing include tax-deductible interest payments, preservation of ownership control, and often lower overall costs compared to equity. Disadvantages involve increased financial leverage, which heightens bankruptcy risk if cash flows falter.

Advantages and Disadvantages of Local Financial Institution Loans

Securing a loan from a local financial institution offers distinct benefits:

- Advantages:

- Personalized service and relationship banking.

- Potential for more flexible repayment terms.

- Faster approval process due to local presence.

- Disadvantages:

- Higher interest rates if the bank perceives higher risk.

- Limited access to larger loan sizes compared to institutional bond markets.

- Collateral requirements may be stringent.

The primary drawbacks involve potentially higher interest costs and stringent collateral demands, which could impact liquidity and flexibility.

Advantages and Disadvantages of Angel Investors

Funding from angel investors introduces an alternative to traditional debt:

- Advantages:

- Access to significant capital without fixed repayment obligations.

- Potential mentorship and business expertise.

- No immediate repayment, easing cash flow constraints.

- Disadvantages:

- Dilution of ownership and control.

- Higher expected return on investment by angels.

- Possible conflicting strategic visions.

Angel investors are often more flexible but demand equity participation, which dilutes existing ownership.

Equity Financing Strategy

Alternatively, financing through equity involves issuing new shares. The current share price is $24, and the company has 4 million shares outstanding, valuing the company at approximately $96 million. To raise $6.9 million via equity:

\[ \text{Number of new shares} = \frac{\$6,900,000}{\$24} \approx 287,500 \text{ shares} \]

This represents roughly 7.19% of the existing shares (287,500 / 4,000,000). Surrendering this proportion of ownership would dilute existing shareholders' stakes, but it avoids debt obligations and interest expenses.

Implications of Equity Financing:

- Dilution of current ownership from 100% to approximately 92.81%.

- No need for interest payments, preserving cash flow.

- Potential for raising large sums quickly if share price remains stable.

Holders of existing shares should consider whether the long-term growth prospects justify ownership dilution and whether the company has a healthy enough balance sheet to sustain more equity issuance.

Conclusion

Considering current interest rates, the company's double AA credit rating, and the amount needed, a balanced approach appears optimal. Issuing corporate bonds at approximately 3.75% interest presents an attractive debt option, offering tax advantages and minimal ownership dilution. However, supplementing with a small equity issuance can provide liquidity without over-leveraging, especially during uncertain economic conditions.

Choosing between local bank loans, which offer flexibility but higher costs, and angel investors, which provide capital without repayment obligations but dilute ownership, depends on strategic priorities. Ultimately, a combination of low-cost debt and selective equity issuance aligns best with maintaining financial stability while funding the new facility.

References

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• Investopedia. (2023). Corporate Bonds. Retrieved from https://www.investopedia.com/terms/c/corporatebond.asp
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