Question

A Company requires a capital infusion of $200,000. It is currently a closely held corporation with less than 50 shareholders. Although the shareholders are not all related to each other, they all know each other and they view the business as a family business. Please refer to the following financial statements:

- ASSETS 2014 - 2013

CURRENT ASSETS

Cash 456,500 - 222,400

Receivables 3,936,400 - 3,320,000

Inventory 89,800 - 100,200

Other assets 119,500 - 84,300

Total current assets 4,602,200 - 3,726,900

LONG TERM ASSETS

Note Receivable 380,600 - 280,700

Equipment (net of depreciation) 975,000 - 1,017,800

Total long term assets 1,355,600 - 1,298,500

TOTAL ASSETS 5,957,800 - 5,025,400

- LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES

Accounts payable 2,783,100 - 2,805,700

Note payable (current maturities) 177,550 - 172,550

Other accrued liabilities 165,300 - 114,600

Total current liabilities 3,125,950 - 3,092,850

LONG TERM LIABILITIES

Notes payable (long term) 354,800 - 354,800

Long term accrued liabilities 289,550 - 220,250

Total long term liabilities 644,350 - 575,050

TOTAL LIABILITIES 3,770,300 - 3,667,900

- STOCKHOLDERS' EQUITY

Common stock 300,000 - 300,000

Retained Earnings 1,887,500 - 1,057,500

Total stockholders' equity 2,187,500 - 1,357,500

TOTAL LIABILITIES AND STOCKHOLDERS EQUITY 5,957,800 - 5,025,400

_________________________

Income Statement 2014 - 2013

Service Contract Revenues 9,700,000 - 6,295,400

Service Contract Costs (7,503,100) (4,957,800)

Gross Profit 2,196,900 - 1,337,600

General and Administrative Expenses (896,000) (756,000)

Operating Income 1,300,900 - 518,600

Gain on sale of equipment 59,900 - 7,700

Interest expense (69,500) (70,800)

Other expense (9,600) (63,100)

Income before taxes 1,281,700 - 455,400

Taxes (451,700) (300,900)

Net Income 830,000 - 154,500

Retained Earnings, Beginning Balance 1,057,500 - 1,053,000

1,887,500 - 1,207,500

Less: Dividends paid 0 - (150,000)

Retained Earnings, Ending Balance 1,887,500 - 1,057,500

___________________________________________________

A number of alternatives are available to the company. It can:

Obtain private debt financing

• Seek out a private investor(s) who would be willing to share ownership

• Seek out offers for a private buy-out

• Issue public debt (corporate bonds)

• Issue public common stock

From the cost of capital point of view, what’s the impact and implications of each alternative? Considering the size of the investment ($200,000) how does this impact of this infusion of capital on the financial statements?

Answer 1

In the given case study we need to evaluate the alternatives available with the company for Capital Infusion. This will hve an Impact on the Company's financial statement which has been discussed below,

1. OBTAIN PRIVATE DEBT FINANCING : In this case the company is going to raise the capital through debt. In oher words it would be borrowing the money of $ 200,000 in the form of a loan. When this happens the following impacts can be observerd.

• Debt carries an Interest rate. Let us assume that this Debt option is available at the rate of 10% interest. Hence the company's expense of Interest will be $ 20,000. Hence in the Income statement there will be a reduction of Income Before Taxes with an amount of $ 20,000. Assuming Corporate tax rate is 35%, then the Net Income will be reduced by $ 13,000 [i.e. $20,000 * (1-0.35). So Retained earnings for the company will be $ 1,874,500
• With this change in the retained earnings, the revised Total Shereholder's equity shall be $ 2,174,500.
• Since the a net Liability is created the Total Liabilities to the company shall be $ 3,970,300 [i.e. 3,770,300 + 200,000]
• Assuming that the company will purchase cetain stock with the infused amount of $ 200,000, correspondingly there will be increase in the Current Assets. Hence revised Current Assets shall be $ 4,802,200 [i.e. 4,602,200 + 200,000].
• There by the Current ratio will change to 1.54 to 1. This signifies better liquidity shatio to the company.
• There will also be a change in the working capital of the company since the company has purchased stock out of the debt borrowings of $200,000. So the new working capital shall be $ 1,676,250.
• The Debt to assets ratio will also incur a change since there is increase in both the assets and debt by $ 200,000. Hence the new debt to Assets ratio shall be 0.64 to 1. So thare is increase in the Debts to Assets ratio.

2. SEEK PRIVATE INVESTOR WILLING TO SHARE OWNERSHIP : In this case the company wands to expand the share capital by issuing certain shares to a private investor. In other words the capital is raised through an existing share holder. So total shareholders shall remain to be 50 in number. So in this case there is a increase in the share capital by $ 200,000. When this happens the following impacts can be observed,

• The common stock increases to $ 500,000 from $ 300,000. Hence the total Shareholders equity shall increase to $ 2,387.500. Hence the percentage growth in the Shareholders Equity in 2014 when compared to 2013 shall increase to 75.87 %.
• Since the capital is raised through issue of shares of the company there shall not be any expense for the company which hits the Income statement. Hence the Net revenue and the retained earnings to the shareholders shall remain to be same.
• Assuming that the company will purchase cetain stock with the infused amount of $ 200,000, correspondingly there will be increase in the Current Assets. Hence revised Current Assets shall be $ 4,802,200 [i.e. 4,602,200 + 200,000].
• There by the Current ratio will change to 1.54 to 1. This signifies better liquidity shatio to the company.
• There will also be a change in the working capital of the company since the company has purchased stock out of the money raised through issue of shares worth of $200,000. So the new working capital shall be $ 1,676,250.
• In this case there is only increase in the Total Assets but there is no change in the Total Liabilities. Hence the new Debts to the Assets ratio shall be 0.61 to 1. So we can see that there is a reduction in the Debt to Asset ratio which is a favourable position to the company in terms of Solvency valuation.

3. SEEKS AN OFFER FOR PRIVATE BUYOUT : In this situation the Public company's shares are purchased by a private company. So The company is going to reduce its share capital by selling it out to a private company. So the existing shareholders are sharing their ownership with a private company. In such the following impacts can be seen,

• There is no change in the common stock of the company since existing shareholders are selling their ownership to another private company. In such case the ownership rights of the 50 shareholders will be reduced to the corresponding amount of capital being infused.
• However the money brought in needs to be paid to the existing share holders. Hence there will not be any change in the financials of the company.
• There will not be any change in the Income statement of the company and at the same time there shall not be any change in the Balance sheet of the company.
• All the financial ratios of the company shall remain unchanged with this option of seeking out an offer for private buy out.

4. ISSUE OF PUBLIC DEBT : In this case the company is issuing new securities in the form of Public Debt securities. This is as similar as taking a loan but since this is in the form of securities which can be traded in the market. These can be sold at a premium rate or for a value lower than the par. These sequrities hall carry a copoun rate at which periodic interest payments need to be made to the holders of the securities. The impacts in this case are as follows,

• Public Debt carries an Interest rate. Let us assume that this Debt securities are issued at the rate of 10% interest. Hence the company's expense of Interest will be $ 20,000. Hence in the Income statement there will be a reduction of Income Before Taxes with an amount of $ 20,000. Assuming Corporate tax rate is 35%, then the Net Income will be reduced by $ 13,000 [i.e. $20,000 * (1-0.35). So Retained earnings for the company will be $ 1,874,500
• With this change in the retained earnings, the revised Total Shereholder's equity shall be $ 2,174,500.
• Since the a net Liability is created, the Total Liabilities to the company shall be $ 3,970,300 [i.e. 3,770,300 + 200,000]
• Assuming that the company will purchase cetain stock with the infused amount of $ 200,000, correspondingly there will be increase in the Current Assets. Hence revised Current Assets shall be $ 4,802,200 [i.e. 4,602,200 + 200,000].
• There by the Current ratio will change to 1.54 to 1. This signifies better liquidity shatio to the company.
• There will also be a change in the working capital of the company since the company has purchased stock out of the proceeds of debt securities of $200,000. So the new working capital shall be $ 1,676,250.
• The Debt to assets ratio will also incur a change since there is increase in both the assets and Liabilities by $ 200,000. Hence the new debt to Assets ratio shall be 0.64 to 1. So thare is increase in the Debts to Assets ratio.

5. ISSUE PUBLIC COMMON STOCK : In this case the Company is issuing public common stock. This will result into increase in the number of share holders. Simultaniously the sharecapital is also increased by $200,000. Under this alternative the following impact can be seen,

• The common stock increases to $ 500,000 from $ 300,000. Hence the total Shareholders equity shall increase to $ 2,387.500. Hence the percentage growth in the Shareholders Equity in 2014 when compared to 2013 shall increase to 75.87 %.
• Since the capital is raised through issue of shares of the company there shall not be any expense for the company which hits the Income statement. Hence the Net revenue and the retained earnings to the shareholders shall remain to be same.
• Assuming that the company will purchase cetain stock with the infused amount of $ 200,000, correspondingly there will be increase in the Current Assets. Hence revised Current Assets shall be $ 4,802,200 [i.e. 4,602,200 + 200,000].
• There by the Current ratio will change to 1.54 to 1. This signifies better liquidity shatio to the company.
• There will also be a change in the working capital of the company since the company has purchased stock out of the money raised through issue of shares worth of $200,000. So the new working capital shall be $ 1,676,250.
• In this case there is only increase in the Total Assets but there is no change in the Total Liabilities. Hence the new Debts to the Assets ratio shall be 0.61 to 1. So we can see that there is a reduction in the Debt to Asset ratio which is a favourable position to the company in terms of Solvency valuation.