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DB 8

Topic: Presentation to the Board of Directors, the Pros and Cons of Debt Financing

The calculation of the after-tax cost of debt versus the cost of equity plays a major role in managing capital costs for a company. Knowing the difference between the cost of debt and the cost of equity would determine how you would manage the cost of capital within a company.

You are the CFO of a company that is considering issuing its first bond issue to the public.

You have been asked to present a few matters related to debt (bond) financing to the board of directors.

Please briefly explain to the board: (1) the usual collateral position of bondholders (lenders) versus equity investors, (2) why common stockholders can demand a higher rate of return than lenders, and (3) why you would suggest debt (or equity) financing.

DB 9

Topic: Modigliani and Miller: A Challenge to Capital Budgeting Strategies

Financing corporate purchases and overall capital budgeting usually require the finance manager to assess tax rates, dividend payout policy, weighting of capital sources, and more. However, the Modigliani and Miller propositions state that, in most situations, it does not matter if the firm's capital is raised by issuing stock or selling debt.

As a student, you might assume studies of capital budgeting strategies will no longer be reviewed in coursework.

Before coming to that conclusion, please discuss the principles presented by Modigliani and Miller, what they are trying to prove within their theory, and if you agree or disagree with the theory's premise.

ASSIGNMENT 8

Assignment: The Angel Investor

In this assignment, you will be assessed based on the following Course Outcome:

MT480-6: Incorporate the combined attributes of debt and equity given a cost of capital model.

The concept of after-tax weighted average cost of capital (WACC) is a foundation when assessing the cost of capital and investment options. The assignment will present the opportunity to assess a financing transaction, build upon your understanding of this cost of capital concept, and demonstrate your ability to calculate the after-tax WACC.

Read the scenario and address the checklist items below.

Scenario: You are an angel investor who an entrepreneur has approached to assess an investment opportunity.

An entrepreneur asks for $100,000 to purchase a diagnostic machine for a healthcare facility. The entrepreneur hopes to maintain as much equity in the company as possible . Yet, the angel investor began negotiations saying he wanted the transaction to be financed with 50% debt and 50% equity.

As the angel investor, you assign a cost of equity of 14% and a cost of debt at 10%. Based on Year 1 sales projections, the entrepreneur assures you a return on investment (ROI) of 9%; conceptually, this will cover the first year’s pretax cost of debt and allow for planned equity growth and refinancing model for Year 2. You will use an after-tax weighted average cost of capital (AT- WACC) model, including the after-tax cost of debt and proportionate costs of debt versus equity. A 32% marginal tax rate is applied.

Address the following checklist items.

Checklist:

· Explain the tax benefits of debt financing.

· Calculate the AT-WACC with a 50% debt and 50% equity financing structure.

· Apply the calculated AT-WACC to explain why this is or is not a viable investment for you as the angel investor.

· Explain a financial restructuring AT-WACC (given changes to proportions of percent debt versus percent equity financing) that would create a positive ROI.

· Explain why you, as the angel investor, would require more or less debt versus equity financing. Be sure to note the role of the Unified Commercial Code-1 (UCC-1) document in this transaction and the order of claim on assets in times of a bankruptcy.

· Include a strong thesis statement, introduction, and conclusion. The main points of the response should be developed and explained clearly with appropriate financial and accounting terminology.