Debt vs. Equity Analysis: Advising a Company on the Best Financing Option, Study notes of Finance

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Debt vs. Equity Analysis:

How to Advise a

Company On Its Best

Financing Option

The Question…

“I have an upcoming IB case study where I’ll have 60 minutes to analyze a company’s financial statements and recommend debt or equity .” “How I should do this? What analysis or qualitative considerations should I include?”

The Short Answer on Debt vs. Equity

• Step 1: Create different scenarios for the company – can be simple , such as lower revenue growth and margins in the Downside case
• Step 2: “Stress test” the company and see if it can meet the required credit stats and ratios in the Downside cases
• Step 3: If not, try alternative Debt structures (e.g., no principal repayments, but higher interest rates) and see if they work
• Step 4: If not, consider using Equity for some or all of the company’s financing needs

Example: Central Japan Railway Case Study

• PROBLEM: Company needs to raise ¥1.6 trillion ($16 billion USD) of capital to finance a new line
• Option #1: Additional Equity funding (would represent 43% of its current Market Cap)
• Option #2: Term Loans with 10-year maturities, 5% amortization, ~4% interest, 50% cash flow sweep, and maintenance covenants
• Option #3: Subordinated Notes with 10-year maturities, no amortization, ~8% interest rates, no early repayments, and only a Debt Service Coverage Ratio (DSCR) covenant

Example: Central Japan Railway Case Study

• Results: DSCR numbers look a bit better in this case, but there were still issues in the Downside and Extreme Downside cases
• One Solution: A different form of Debt that uses “sculpting,” as in Project Finance or Infrastructure, to vary the interest and principal repayments over time (ramp up as project is completed)
• But: Here, we have only three options, so we must use more Equity – try 25% or 50% Equity to start with
• Simulate By: Setting the EBITDA multiple for the Debt to 1.0x or 1.5x instead (so the remaining 1.0x or 0.5x is Equity)

Example: Central Japan Railway Case Study

• Results: 50% / 50% Subordinated Notes / Equity is better if we strongly believe in the Extreme Downside case; 75% / 25% is better if the normal Downside case is more plausible
• Qualitative Factors: You can then use these to back up your recommendations based on the numbers
• Point #1: Extremely high EBITDA margins, low revenue growth, and stable cash flows due to near-monopoly – ideal for Debt
• Point #2: Limited downside risk in the next 5-10 years; population decline in Japan is more of a concern over several decades