Businesses find themselves in need of extra capital even if they are making profits. There are two major ways through which these businesses can raise additional capital for their businesses. These methods include equity and debt capital. Equity capital is where a company divides its ownership into small units called shares (Ahuja, Narender). These shares are sold to various people at a predetermined fixed share price in order to raise capital for the business. The shareholders own a percentage of the company and they have various rights as outlined in the companies act. They benefit from the companies` dividends when a company makes profits. Another method of raising capital for businesses is the debt capital financing. This is where a company or organization borrows funds from a financial institution or an individual and repays it later at an interest. Debt financing is used by most companies as most of them do not want to lose control of their ventures by sharing ownership (Mullins, John).There are various advantages and disadvantages of using either of the methods. This paper analyzes the reasons why MacDonald needs to borrow to support his growing business. The problem that MacDonald is facing in this case is mainly due to overstocking hence leading to cash flow problems for the company. MacDonald has a variety of other options that he can exploit in order to raise capital. One of them as stated above is seeking to sell shares or by selling debentures (Bilgin, Mehmet , Hakan Danis, Ender Demir, and Ugur Can).Also contained in this paper are projected financial reports for Albercan drilling and a detailed analysis of the same.
The major reason why McDonald needs to borrow in order to finance Albercan drilling despite the company making good profits is so that the company can solve its cash flow problems. The company has fallen into cash flow problems because of its decision to increase its inventory by a very large margin. This decision has resulted in the companies` cash outflows exceeding cash inflows (Kim, Joon Ho). These cash flow problems for the company were brought about by the decision of McDonald to buy the share ownership of Mr.Kelly who decided to exit the business. Due to this reason, it is vital that ADS seeks additional investment so as to be able to run the operations of the company smoothly.
Another reason why ADC needs to borrow despite making reasonable profits is that the company has a growth plan and vision. In order to achieve this vision, it is important that the company borrows money in order to facilitate its growth and expansion plans. The company has been growing at a consistent rate over the previous 10 years and the profits have been increasing persistently. This growth however is threatened by the reduction in cash from the business as a result of acquiring the stake belonging to Mr Kelly. If the company’s growth projections are met, it will be easy for the company to repay the loans and consequently increase its profits. The investment from the loan from the bank will generate enough cash to cover the cost of borrowing. The company can increase its product portfolio and increase its stock to more diverse and modern drilling equipment.
In addition to this, the borrowing by ADC can help the company to advertise more and get more customers for its business. The company can now start selling drilling pipes to larger drilling companies who buy directly from the manufacturer. This will be possible since the company can enjoy large economies of scale and quantity discounts which will help the company to price its products cheaply so that more clients can be attracted to buy its products (Panzarino, Helene).
Borrowing money for the company will also help to reduce the personal risk for McDonald. Instead of McDonald selling his other prized personal assets to fund the business, it is more prudent for him to borrow a loan since he will not risk the livelihoods of his family.
McDonald has many other options available to him. Apart from borrowing from banks and other financial institutions, ADC can sell debentures in order to raise money to fund the company. A debenture is an unsecured debt that is backed only by the company and there is no collateral for the debt. The advantage of this form of funding is that the company does not risk its assets and the cost of the debt may not be as high as financing a loan from a financial institution. Alternative, McDonald can decide to seek for a strategic investor who he can sell a portion of his shares to. This can easily help the company to raise large sums of money to fund growth. The investor will enjoy ownership rights such as sharing in the companies` profits. The strategic investor is also referred to as Angel investor. Another alternative available to McDonald is raising additional capital through family members and friends. Even thou this is mostly common for small start up business, McDonald can still manage to raise a significant amount by selling part of his personal possession and assets in order to invest in the business. This can be boasted by support from close family members and friends. This method is risky for family members and cannot be relied to raise large amounts of capital.
Cost of sales (70%) 3,080
Gross profit 1,320
Operating expenses (21% of sales) 924
Interest (Mortgages+ Notes+ New) 18+4+24 =46
Operating expenses 878
Profit before taxes 442
Taxes due(40%) 177
Living expenses 168
Total Drawings 345
Profit Left in Business 97
Cash 34 notes payable 302
Accounts receivable (52 days) 566 Accounts payable 298
Inventory (98 days) 744 Accrued Expenses 80
LTD Current 8
Current assets 1320 Current Liability 688
Mortgage debt 300
Property 258 Retained Earnings 84
Current Profit 97
Total Liability $ Equity 1,169
Additional Bank Loan 200
Total Assets 1,578 Total Liability & Equity 1,369
AlberCan Drilling Supply Company - Projected 2009 profit and Loss Statement(Canadian $ in 000`s)
Cost of sales (70%) 3,850
Gross profit 1,650
Operating expenses (21% of sales) 1,155
Interest (Mortgages+Notes+New) 18+4+48 =70
Operating expenses 1085
Profit before taxes 565
Taxes due(40%) 226
Living expenses 174
Total Drawings 400
Profit Left in Business 165
Cash 54 notes payable 302
Accounts receivable(52 days) 566 Accounts payable 225
Inventory(98 days) 767 Accrued Expenses 80
LTD Current 8
Current assets 1387 Current Liability 615
Mortgage debt 240
Property 267 Retained Earnings 84
Current Profit 97
Total Liability $ Equity 1,036
Additional Bank Loan 160
Total Assets 1,654 Total Liability & Equity 1,196
The projected statement of profit and loss for the company provides very crucial information. This information can be used by various stakeholders in the company such the owner and the lending institution to make decisions for the company (Qfinance).In the projected profit and loss statement for the year 2008, the companies sales are estimated at $4,400,000. The prediction of sales for the year 2008 is based on previous three years growth in sales volumes for ADS. The projection of sales volumes is also informed by the growth plan of the company. The company is planning to diversify to drilling pipes of other sizes and also to increase its customer base to middle sized companies. With this plan, the company will be able to achieve its projected sales revenues. This projected sale for the company in the year 2009 is expected to increase by 20% to become $5,500,000. This means that the company expects to increase its sales volumes by 20% as a result of increased investments.
It is also estimated that the cost of making the sales will remain proportionally the same as the previous year. This is fixed at 70% of the sales revenue. This is approximately $3,080,000.This is expected to rise in the year 2009 since the sales revenues will rise. Therefore, the cost of sales for the year 2009 will be $3,850,000. The largest proportion of cost of sales is the cost of buying from the manufacturer. The rest is the cost of transporting the materials from the manufacturer to the warehouse. From the calculations, the gross profit for the company for the year 2008 is $1,320,000. This is an increase compared to what was achieved in 2007 sale of $1,040. The operating expenses for the company are retained at 21% of the total sales. The projected operating expenses for the year 2008 are therefore expected to be $924. The interest expense for ADS is a combination of the mortgage interest, the interest on notes and the interest from the expected new loan of $200,000. The total interest expense for the year adds up to $46.In the year 2009, the interest expense increases to $70,000. This huge increase is due to the increased regulations which increases the mortgage interest rate to 12%.The total operating expense for the company is $878,000, this is expected to increase for the year 2009 to $1,085. The increase is due to the increase in cost of marketing the company increasing in order to achieve the targeted sales. The profit before tax for the year 2008 is $452,000 and it increases to $565,000 in the following year. Thus is attributed to increase in sales revenues hence causing a proportional change in the profit before taxes. The tax rate for the company is fixed at 40% of the profit before tax. The tax rate for the company does not change and this therefore means that it does not have a huge effect on the loan that McDonald is applying for (Zhang, Shage).
The balance sheet for AlbaCan drilling company for the year 2008 and 2009 also provide very crucial information for the lender. It is important to analyze the projected balance sheet for the two years in order to determine the risk level of the business and the value of the company’s assets. The projected total assets for ADS in the year 2008 are $1,578,000. The company expects the total assets to increase up to $1,654 for the year 2009. The increase is mainly due to increase in the inventory of the company as well as other current assets. The total liabilities for ADS are very crucial in the bank’s decision on whether or not the bank should advance loan to ADS. The liabilities for the company are huge for the year 2008 and they are expected to increase further in the year 2009. The mortgage of the company is the main long term liability for the company and it has experienced problems in repaying the loan. The bank also owes suppliers to the tune of $225,000. The companies working capital is also not impressive. From the above analysis,it is clear that the businesses future prospects are promising even thou the debt capital seems to become a burden for the company in future. Under the conditions that the bank has given ADS company, I would lend out the amount if I were in the banks` position. The increase in interest to 12% would be profitable for the bank and the other conditions would also be crucial in ensuring that ADS commits itself to repaying the loans.
As MacDonald, I would not take the loan. This is because the conditions offered for the loan are too stringent. Firstly, the cost of financing the loan is too high. In this case, its double the normal market rate of offering credit. This therefore means that the loan will not be able to bring huge returns as expected. The requirement of paying 20% of principal every October means that the company may not be able to implement its growth agenda as planned. The loan being borrowed is also seen to affect the previous mortgage loan taken by the company and therefore it would not be in the interest of the company to interfere with the terms of the previous loan. The loan condition of not taken any short term loan by the company would also have very negative effect on the company. This is because the company may in the future find itself in cash flow problems that may make it necessary to borrow a short term loan. The company may also find a very good investment opportunity with quick returns and due to these restrictions it may miss this opportunity. Therefore under these circumstances, it is unwise for the company to proceed with accepting the terms of the loan.
An in depth evaluation of the various sources of capital for various businesses has done. The major sources of capital for most businesses are debt capital or equity. Debt capital is the funding of a business from borrowed funds which carry an interest. Some of the advantages of borrowing to finance a business is that the owners do not lose control of the company and they do not have to share the profits with a third party. Equity funding is where a company sells shares in order to raise funds. It has various advantages and disadvantages which have also been clearly discussed in the paper. The reasons of seeking additional funding for ADS are also clearly outlined in the paper. Projected financial statement for the company for two years is then prepared. The statements are then analyzed in detail to help advice Mr.MacDonald and his company on whether or not he should take the loan and the conditions provided by the bank. The banks position in regard to the state of the company’s projected financial statements and whether or not it would be prudent to extend the loan to ADS.
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