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Vuyo Kholisi is well on his way to starting a new business venture-Vuy Inc
Vuyo Kholisi is well on his way to starting a new business venture-Vuy Inc. He has projected a need for R350,000 in initial capital. He plans to invest R150,000 himself and either borrow the additional R200,000 or find a partner who will buy equity stock in the company. If Vuyo borrows the money, the interest rate will be 6 percent. If, on the other hand, another equity investor is found, he expects to have to give up 60 percent of the company's stock. Vuyo has forecasted earnings of about 16 percent in operating profits on the firm's total assets.
i. Compare the two financing options in terms of projected return on the owner's equity investment. Ignore any effect from income taxes.
ii. Supposing Vuyo is wrong, and the company earns only 4 percent in operating profits on total assets, decide on the two financing options.
iii. Describe what should Vuyo consider in choosing a source of financing Prepare a cash budget for January, February and March.
Expert Solution
Answer i
Computation of net left income left for Vuyo
| Debt Option | Equity Option | |
|---|---|---|
| Operating Profits | R56,000 (R350,000 * 16%) | R 56,000 (R350,000 * 16%) |
| Interest Costs | R12,000 (R200,000 * 6%) | - |
| 60% of Earnings for equity investor | - | R33,600 (R56,000 * 60%) |
| Earnings for Vuyo | R44,000 | R22,400 |
If the operating profit is 16%, then Vuyo should opt for the debt option.
Answer ii
Computation of net left income left for Vuyo
| Debt Option | Equity Option | |
|---|---|---|
| Operating Profits | R14,000 (R350,000 * 4%) | R 14,000 (R350,000 * 4%) |
| Interest Costs | R12,000 (R200,000 * 6%) | - |
| 60% of Earnings for equity investor | - | R8,400 (R14,000 * 60%) |
| Earnings for Vuyo | R2,000 | R5,600 |
If the operating profit is 4%, then Vuyo should opt for the equity option.
Answer iii
Factors to be considered in choosing a source of financing
- Cost of Funds - Vuyo should considered that cost involved in arranging the funds, for debt he would be liable to pay interest where for equity he would have share his earnings.
- Dilution of Ownership - Vuyo should consider whether he wants to dilute his ownership in the company? Debt option prevent dilution in ownership whereas Equity option would involve risk that Vuyo would lose control of his business.
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