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If this investment was financed entirely with debt, the new capital structure would be 67.2% debt and 32.8% equity. If this investment was financed entirely with equity, the new capital structure would be 30.5% debt and 69.5% equity.
One rule of thumb for making such a decision is to match the asset type with the financing. Therefore, an asset that is expected to have a service life of five years would be financed with a five-year bond issue, so that the cash flows from the asset can be used to cover the costs of financing. In this case, the asset life is not known, so any financing type can be used.
Internal cash is not possible because the firm likely does not have $10 million in cash if it only has $17.2 million in assets and $17.5 million in annual revenues. A debt issue will leave the firm with a significantly higher degree of leverage, increasing the firm's risk level. In order to know if this risk level is acceptable, it is worth considering the industry norms. Canadian auto part supplier Magna carries a capital structure featuring 40.2% debt and 59.8% equity (MSN Moneycentral, 2010) so it appears that 67.2% debt is probably too high for our auto parts company.
If equity is to be used to finance this project, there are still a couple of different options, including common shares and preferred shares. In this case, there is the risk of using common shares that ownership could be diluted. This dilution can be eliminated by issue rights to the existing common shareholders, allowing them to maintain their current level of holding in the firm's equity.
The project has a positive net present value or it would not be considered. Assuming that it makes sense on a strategic level, the company should pursue the investment. Although this project will dramatically increase the size of the company, the decision needs to be made based on rational economic criteria. Thus, if the project can be financed and will result in a positive net present value for the firm, it should be pursued.
It should also be considered that at present the company only earns $5,000 in revenue per employee. This means that the company as currently constituted is probably not viable. It needs to grow in order to pay for all of those employees, so this project is likely required for strategic reasons as well.
Because of the size of the project relative to the size of the company, it is risky. The current shareholders should be asked to finance this project, as using debt would dramatically alter the company's capital structure and bring it far from industry norms. In order that existing shareholders finance the project, the equity should be raised through a rights issue that allows current shareholders to maintain their investment in the company as it grows.
The rights issue would raise the $10 million needed for this project. Using equity will shift the capital structure closer to that of Magna. The project should be expected to be a major contributor of revenues for our company, so it is reasonable that the equity shareholders be asked to finance the project. The rights would give existed shareholders the option to buy more equity in the firm as a discounted price. There would be no dilution of control, unlike a standard equity issue. There would be no cash flow obligations created, unlike debt or preferred shares. The project's future cash flows would be used either to fuel further growth or to pay dividends back to the shareholders as a way of returning to them their investment.
Investopedia. (2010). Net present value -- NPV. Investopedia. Retrieved October 2, 2010 from http://www.investopedia.com/terms/n/npv.asp
Wang, J. (2003). Capital asset pricing model. MIT. Retrieved October 2, 2010 from http://web.mit.edu/15.407/file/Ch11.pdf
Yahoo! Finance. (2010). Advanced bond screener. Yahoo!. Retrieved October 2, 2010 from http://reports.finance.yahoo.com/z1?b=1&so=a&sf=m&tt=1&stt=-&pr=0&cpl=-1&cpu=-1&yl=-1&yu=-1&ytl=-1&ytu=-1&mtl=6&mtu=24&rl=-1&ru=-1&cll=-1
MSN Moneycentral. (2010). Magna International financial statements. MSN Moneycentral. Retrieved October 2, 2010 from http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=MGA&lstStatement=Balance&stmtView=Ann[continue]
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