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John’s Barley Mill is considering adding a new production line to its existing facility. The new...

John’s Barley Mill is considering adding a new production line to its existing facility. The new production line will increase John’s sales revenue by $1 million/year. Sales of this offering have a gross margin of 70% and the cost of operating the new line is another 50% of sales on an annual basis. The company does not have any excess capital to invest in this project beyond what they acquire through the debt/equity associated with this project.

The new production line will cost $3 million to develop and install. The expected lifetime of this new equipment is 10 years.

The company has the opportunity to finance this purchase through their bank with debt financing at 9% per year over 5 years.

The company can also accept equity financing from an outside investor. They will have to give this new investor 20% ownership in the company in exchange for these funds.

The company currently has a market valuation of $20 million. If it continues to hit its projections, which are extremely conservative based on this investment, the valuation will increase by at least 10%/year in this environment. If they do not make this investment, then the value of the firm will remain constant over the same period of time.

(1) Would equity or debt financing be preferable given the terms presented?

(2) Should John move forward with this investment?
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Homework Answers

Answer #1

1)

Given that the company already has a market valuation of $20 million, providing a 20% ownership to a growing company with strong fundamentals appears to be a bad deal especially when the quantum offered by the investor is just $3 million. The company already has strong credentials meaning that the company will not face much issues in gaining a bank loan and 9% is a very standard rate for debt financing. Further it would not dilute equity and the debt would be gone in a period of 5 years. Although I agree that debt financing will involve negative cashflows over the next 5 years, The net outgo would be close to  

₹ -38,56,386.85

but I believe that is much better than an ownership of close to a minimum of $6.4 million in 5 years time .

2)

No John should not move forward with the investment and should go for debt finance instead.

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