Debt vs. Equity Analysis: How to Advise a Company On Its Best Financing Option

Debt vs. Equity Analysis: How to Advise a Company On Its Best Financing Option

The Question I have an upcoming IB case study where I ll have 60 minutes to analyze a company s financial statements and recommend debt or equity. How I should do this? What analysis or qualitative considerations should I include?

The Short Answer on Debt vs. Equity Cost: All else being equal, companies want the cheapest possible financing Debt: Tends to be cheaper than Equity because interest paid on Debt is tax-deductible, and lenders expected returns are lower than those of equity investors (shareholders) BUT: There are also constraints and limitations on Debt the company might not be able to exceed a certain Debt / EBITDA, or it might have to keep its EBITDA / Interest above a certain level So: You test these constraints first and proceed accordingly

The Short Answer on Debt vs. Equity Step 1: Create different scenarios for the company can be simple, such as lower revenue growth and margins in the Downside case Step 2: Stress test the company and see if it can meet the required credit stats and ratios in the Downside cases Step 3: If not, try alternative Debt structures (e.g., no principal repayments, but higher interest rates) and see if they work Step 4: If not, consider using Equity for some or all of the company s financing needs

Example: Central Japan Railway Case Study PROBLEM: Company needs to raise 1.6 trillion ($16 billion USD) of capital to finance a new line Option #1: Additional Equity funding (would represent 43% of its current Market Cap) Option #2: Term Loans with 10-year maturities, 5% amortization, ~4% interest, 50% cash flow sweep, and maintenance covenants Option #3: Subordinated Notes with 10-year maturities, no amortization, ~8% interest rates, no early repayments, and only a Debt Service Coverage Ratio (DSCR) covenant

Example: Central Japan Railway Case Study PROCESS: Start with the Term Loans (Option #2) since they re the cheapest form of financing (~4% interest rates) Evaluate how the required credit stats and ratios look in different cases, focusing on the more pessimistic ones how lenders think! PROBLEM: It would be almost impossible for the company to comply with the minimum DSCR covenant, even in the Base case, and it looks far worse in the Downside cases Next Step: Try the Subordinated Notes instead lack of principal repayment will make it easier to comply with the DSCR

Example: Central Japan Railway Case Study Results: DSCR numbers look a bit better in this case, but there were still issues in the Downside and Extreme Downside cases One Solution: A different form of Debt that uses sculpting, as in Project Finance or Infrastructure, to vary the interest and principal repayments over time (ramp up as project is completed) But: Here, we have only three options, so we must use more Equity try 25% or 50% Equity to start with Simulate By: Setting the EBITDA multiple for the Debt to 1.0x or 1.5x instead (so the remaining 1.0x or 0.5x is Equity)

Example: Central Japan Railway Case Study Results: 50% / 50% Subordinated Notes / Equity is better if we strongly believe in the Extreme Downside case; 75% / 25% is better if the normal Downside case is more plausible Qualitative Factors: You can then use these to back up your recommendations based on the numbers Point #1: Extremely high EBITDA margins, low revenue growth, and stable cash flows due to near-monopoly ideal for Debt Point #2: Limited downside risk in the next 5-10 years; population decline in Japan is more of a concern over several decades

Recap and Summary Companies: Want the cheapest funding possible for expansion projects, acquisitions, etc. which usually means Debt But: But Debt also has constraints, and you have to see if the company can comply with those constraints in Downside cases Yes: Easy, use the proposed Debt package! No: Try other options for Debt, and add Equity if necessary And: Use the qualitative factors to support your recommendation