Winfield Refuse’s acquisition of MPIS was a great opportunity to increase revenue and reduce costs through economies of scale. However, the expansion of the firm also means that Winfield Inc. needs to select a method of external financing to continue its operations effectively. The Winfield family and senior management held 79% of common stock in 2012.
This means the company places tremendous importance in the ownership of company. The acquisition of MIPS should not change the stakes of ownership of Winfield Refuse. Board Discussion 2012
CFO Mamie Sheene recommended issuing bonds, based on an annual cash cost calculation of 6% for stock issuance. Her rationale was that Winfield could sell $125 million in bonds to Massachusetts insurance company at an annual interest rate of 6.5% set to mature in 15 years. Principal repayment would be $6.25 million, leaving $37.5 million outstanding in 15 years. Her presentation was not received pleasantly. Some of the board members believed this is another long-term commitment the company cannot afford to make. The idea of equity based financing was placed on the table. Alternatives:
Debt with Fixed Principal Repayments
Having an investor write a check to the company seems like a simple and quick answer to a financial problem. Winfield would be able to effectively expand without taking on debt.
There is no interest associated either. This is also a less risky method of injecting funds to the business than a loan. There is also no requirement to payback if the business fails. Cash on hand can be beneficial to the expansion expenses associated with the recent acquisition of MPIS. However, this check comes along with a major commitment.
An equity financing option could require a higher rate of return than a bank. The investor gains some ownership of the company and percentage of profits. The senior management will have to consult with the investor prior to making most decisions, which can lead to various internal conflicts through disagreements. Giving up an amount of control of Winfield could be detrimental to its business model. Debt Financing
On the other hand, the issuance of bonds to fill the need for additional capital to expand does not require handing over a part of the company. Massachusetts insurance has no say in how the management runs Winfield after issuing bonds. The business relationship between the two institutions will terminate in 15 years (at maturity).
The principal and interest are known figures that can be built into the company budget over the upcoming years. Still, money borrowed must be paid back. Taking on too much debt can cause cash flow problems, which can mean difficulty to repay the loan back. If Winfield has too much debt, it can be seen as “high risk” by potential investors, limiting ability to raise capital by equity financing in the future. Debt financing can also increase the vulnerability of the business during hard times (though it seems Winfield was not greatly affected by the recent recession).
Debt can also make it difficult for the company to grow, as the cost of repaying the loan is vital to the business. Company assets can be held as collateral and owner of Winfield maybe personally require guarantee of the loan. Recommendation
Winfield’s net income was $27million. With the Acquisition of MPIS and its $15 million net income, the business can expect a $42 million net income. The company’s current debt-to-equity ratio is 50:50. First option is to issue debt with an annual 6.5% interest rate and $6.25 million annual principal, the company could be left on a tight budget, making payments difficult.
Another option to issue debt without fixed payments, and full principal to be paid at date 15, assuming the same 6.5% interest rate. A $125million repayment at year 15. Third option to finance through equity to fill the need for $125M means issuing 7.5 million new shares at $17.75 per share. Maintaining the $1.00/ share dividend policy, means a negative impact to shareholders. The EPS would drop to $1.91 with the increase in number of shares vs. a $2.51 EPS with debt financing. Winfield should finance the $125 million through issuance of bonds without fixed principal payments.
This would avoid diluting control of the company to investors while also allowing sufficient cash flow for expansion (increasing flexibility). Though earnings would be reduced by interest, the expected EPS is higher under usual EBIT instances than through equity financing. The cost of financing is also the least for the option of debt without principal repayments.