Determining the Debt-Equity Mix Summary

RUNNING HEADER: DEBT-EQUITY SIMULATION

Determining the Debt-Equity Mix Summary

Determining the Debt-Equity Mix Summary

El Cafй is a recently founded coffee shop with some very typical business decisions to make within the simulation. Decisions which include expanding communities, selecting a debt-equity mix, avoiding bankruptcy are all involved within this simulation to make the business a profitable one. Being in a business that has a relative as a potential investor, financial strife and capital it’s important to make sure the decisions that are being made are ones that are for the better of the company.

Within the first scenario that was to be completed the debt-equity mix that is involved with the company and it’s financing. The business partner, Uncle Jorge, offers to give all the money needed for the company as long as the finances will be going through him. With this decision it would give him a seat as a primary stockholder for the company and basically put all the control in his hands. After reading through the information provided within the summary, a 30% equity and 70% debt mix is the best to use because the interest rates are low and are available in the city, not to mention that the business has a tax exempt status. In order for the equity component to be low, the weighted average cost of capital would have to be low as well. Because the cost of equity is higher than the cost of debt this is a true statement. Typically debt helps a company save money on taxes being able to put it into the tax deductible category. The problem that you have to keep in mind is that since the company is tax exempt, the goal is to make sure that the ownership of this company does remain where it currently is. To be able to ensure that the equity will remain on your side of the table and not Uncle Jorge’s side, choosing a high debt, and low equity model is the key to remember.

Scenario two is the fact that an optimal expansion strategy to spread the company into multiple cities around the area is another decision that has to be made. In the simulation by choosing a 7 city expansion with an all dept option, I was able to find out that this would be the most viable option for the time being since the rate of return is high and the weighted average cost of capital is low. When having a business, a decision that involves finances can only be justified if the expected rate of return is higher than that of the weighted average cost of capital. Since debt does cost less than equity does, and debt also does help to lower the weighted average costs of capital it’s easy to see the outcome. One other thing in the simulation is that taxes are no longer in exemption, the payments made on the business’s debt will help to lower interest rates and tax deductions can be applied. By doing this, the scenario starts the “tax shield” phenomenon of the higher the debt, the lower taxes; however bankruptcy starts to be a major threat and problem at this point.

In the last scenario the company must avoid the risk of going bankrupt. Many options are available that can be used in order to avoid this devastating problem Some of the options can include selling assets, renegotiating debt, and swapping debt for newly obtained equity. Debt and equity