This is a topic that comes up frequently in higher level strategy papers, which students often find difficult. The key to answering these questions is having a structured approach and tailoring your answer to the organisation in the question. By following the approach below you should demonstrate both.
Look at the company’s current position.
- What’s their cash flow like – could they afford regular interest payments?
- Are they quoted which gives them access to capital markets?
- What’s their current gearing and how does this compare to the optimal (industry average)?
- Are there any covenants on existing finance which restricts them from future borrowing?
- Do they have assets available for security?
Then look at the project they are raising finance for.
- What assets does it require – could they be used as security?
- How long does it last – we want to try and match the length of the project with the term of the finance
- What risk does it involve? How will that impact on the overall risk of the company?
- How much cash will it drain from the business in the early years?
Now you are ready to think about the alternatives.
They might suggest 2 or 3 alternatives in the question for you to debate or the question might be quite open ended, in which case, think about the different categories of debt and equity rather than just mentioning those in general (debt being cheaper than equity but riskier for the company is a good starting point but you need more!). Here’s some useful elements to consider:
- Equity – retained profits (if cash in the bank available), delaying a dividend (but how would that impact on shareholders), rights issues (do the existing shareholders have available cash), venture capital (high returns demanded, exit route, control), floatation (takes time, dilution of control etc)
- Debt – bank loan (easy to arrange, good for matching), irredeemable (never repay the capital, interest into perpetuity), redeemable (can structure it with low coupon rate and high redemption to ease immediate cash flow or vice versa), convertible (may not need to build up cash for redemption but could cause control issues).
That should give you a nice structure to answer a question – just make sure you are always tailoring it to the scenario!