Reasons why McDonald needs to borrow to finance his profitable business

There is always a requirement of extra capital in business even if it makes profits which can be done through debt capital and equity. When the ownership of the company is broken into small shares then equity capital is generated. Each share holds a fixed price which is bought by other people to raise the capital (Jensen and Michael). The rights of the company are given to the shareholders as per rules given in company act. Dividends are paid from the profits made by the company. When funds are borrowed from any person or a financial institution with condition of interest repayment then it is called debt capital. This method is used more often because equity capital makes owners lose their rights of the company. Both methods have their pros and cons. Cash flow has become the major issue in case of MacDonald due to overstocking. To raise capital MacDonald can raise debentures and sell shares. This report contains analysis of Albercan drilling as well.

Albercan drilling needs to be financed in spite of the profits being made is because of the cash flow issues of the company are disturbing MacDonald. The cash flow issue has come up due to unprecedented increase in the company’s inventory which has increased the cash outflows more than its inflows (Merton and Andre Perold). Cash flow problems have started when McDonald bought the shares of Mr. Kelly who left the business. Due to this reason ADS has to arrange more money for smooth running of its business.

ADS is looking forward to expand and grow and for that it needs more money as working capital. For the execution of growth and expansion vision it needs capital. ADS has shown consistent growth since last decade and made continuous profits. But after buying the shares of Mr. Kelly the growth has taken a dip. If the company grows at its previous rate then it can easily payback its loan and can make profit like before. Diversifying its drilling equipment into modern one, will make its stock increase and hence its product portfolio.

Debit financing can assist ADS to spend in advertisement and reach more customers. They can sell drilling pipes on a wholesale rate to small companies. This will create price leverage where ADS can lower the cost of their drilling pipes to attract more customers.

Debit Financing will free MacDonald from any personal risks. He won’t have to sell his personal belongings in the form of shares to raise the capital and loan will make him more secure.

Analysis of the projected financial statements

MacDonald also has the option of selling debentures to raise capital. Debentures are loans without collateral which are unsecured and backed by the company itself. Debentures do not have high interest rates as banks and all the assists are secured. Alternatively, McDonald can sell some shares to a strategic investor or an angel investor to raise money. The investor will become co-owner of the company and will share profits. Mc Donald can borrow from his friends and family also. He can also sell his personal possessions to raise capital but is too risky to be tried.

The projected statement of profit and loss for the company provides very crucial information which can be used by various stakeholders in the company such as the owner and the lending institution to make decisions (Brealey and Richard). In the projected profit and loss statement for the year 2008, the company’s sales are estimated at $4,400,000. The prediction of sales for the year 2008 is based on previous three years growth in sales volumes for ADS. The projection of sales volumes is also informed by the growth plan of the company. The company is planning to diversify to drilling pipes of other sizes and also to increase its customer base to middle sized companies. With this plan, the company will be able to achieve its projected sales revenues. This projected sale for the company in the year 2009 is expected to increase by 20% to become $5,500,000. This means that the company expects to increase its sales volumes by 20% as a result of increased investments.

It is also estimated that the cost of making the sales will remain proportionally the same as the previous year. This is fixed at 70% of the sales revenue. This is approximately $3,080,000.This is expected to rise in the year 2009 since the sales revenues will rise. Therefore, the cost of sales for the year 2009 will be $3,850,000. The largest proportion of cost of sales is the cost of buying from the manufacturer. The rest is the cost of transporting the materials from the manufacturer to the warehouse. From the calculations, the gross profit for the company for the year 2008 is $1,320,000. This is an increase compared to what was achieved in 2007 sale of $1,040. The operating expenses for the company are retained at 21% of the total sales. The projected operating expenses for the year 2008 are therefore expected to be $924. The interest expense for ADS is a combination of the mortgage interest, the interest on notes and the interest from the expected new loan of $200,000. The total interest expense for the year adds up to $46.In the year 2009, the interest expense increases to $70,000. This huge increase is due to the increased regulations which increases the mortgage interest rate to 12%.The total operating expense for the company is $878,000, this is expected to increase for the year 2009 to $1,085. The increase is due to the increase in cost of marketing the company increasing in order to achieve the targeted sales. The profit before tax for the year 2008 is $452,000 and it increases to $565,000 in the following year. Thus is attributed to increase in sales revenues hence causing a proportional change in the profit before taxes. The tax rate for the company is fixed at 40% of the profit before tax. The tax rate for the company does not change and this therefore means that it does not have a huge effect on the loan that McDonald is applying for.

Conclusion

The balance sheet for Albercan drilling company for the year 2008 and 2009 provide crucial information for the lender. Analysis of project balance sheet of two years will show the value of assets and risk level of the company. The projected total assets for ADS in the year 2008 are $1,578,000. The company expects the total assets to increase up to $1,654 for the year 2009. The increase is caused by inventory and current assets of the company. Total liabilities will decide the fate of the loan for the company. The liabilities for the company are huge for the year 2008 and they are expected to increase further in the year 2009. The mortgage of the company is the main long term liability for the company and it has experienced problems in repaying the loan. The bank also owes suppliers to the tune of $225,000. The company’s working capital is also not impressive. From the above analysis, it is clear that the businesses future prospects are promising even thou the debt capital seems to become a burden for the company in future (Bhide and Amar). Under the conditions that the bank has given ADS Company, I would lend out the amount if I were in the banks` position. The increase in interest to 12% would be profitable for the bank and the other conditions would also be crucial in ensuring that ADS commits itself to repaying the loans.

I would not have borrowed money on such tough terms offered for the loan. Cost of financing loan is double that of market rate. If ADS has to pay 20% of its principal every October then it will not bring any growth or profits. The new loan will hamper the previous loans on mortgage which will make things difficult for ADS. Restriction on short terms loans to be borrowed in future may become problematic to solve the cash flow problem. Quick returning of the loan can be beneficial for ADS but a restriction on its terms creates a huge problem. Hence it makes it clear that taking loan on these terms is a bad idea.

Conclusion

This report is reflection of all the sources of capital investment. Equity and debt capital were found to be the best options. Debt is paid back with interest after being borrowed but the owners retain the rights and profits of their company. Selling shares of the company makes equity capital and its pros and cons are discussed above. Analysis of projected financial statement is done to help Mr. MacDonald for taking loan for his company from the bank. Financial statement projects the place of bank’s interest in financing and if they are going to ADS for loan extension or not.

References

Bhide, Amar. “Reversing corporate diversification.” Journal of Applied Corporate Finance 3.2 (2012): 70-81.

Brealey, Richard A., et al. Principles of corporate finance. Tata McGraw-Hill Education, 2012.

Cumming, Douglas, Grant Fleming, and Armin Schwienbacher. “Style drift in private equity.” Journal of Business Finance & Accounting 36.5?6 (2013): 645-678.

Jensen, Michael C. “Agency costs of free cash flow, corporate finance, and takeovers.” The American economic review 76.2 (2014): 323-329.

Merton, Robert C., and Andre Perold. “Theory of risk capital in financial firms.” Journal of Applied Corporate Finance 6.3 (2012): 16-32.

Rose, Nathan. Equity Crowdfunding: The Complete Guide for Startups and Growning Companies. , (2016). Print.

Stern, Joel M., G. Bennett Stewart, and Donald H. Chew. “The EVA® financial management system.” Journal of applied corporate finance 8.2 (2012): 32-46.

Stulz, René M. “Golbalization, corporate finance, and the cost of capital.” Journal of applied corporate finance 12.3 (2013): 8-25.