Judgment Case 3-11: Debt vs Equity Financing
Jessica M. Opfer
Liberty University Online
ACCT 301: Intermediate Accounting I
Professor Justin Miller
April 7, 2021
Judgment Case 3-11 Debt vs. Equity
Debt versus Equity financing
Cherokee Plastics Corporation has the option to do an equity-only financing or a
combination of equity and debt financing. Cherokee Plastics corporation needs a total investment
of at least $50,000,000 to get started. The company states there will be a 10% return every
year and the income tax rate is stated at 25%. Debt financing is getting your capital from a
creditor and you are obligated to pay them on a monthly basis. Equity financing is a safer option
because you only pay back your investment when you start to make money. “Since there are no
required monthly payments associated with equity financing, the company has more capital
available to invest in growing the business” (Maverick, 2019).
1: Abbreviated income statements, first-year profitability
The first option for financing is an equity-only option and an initial investment of
50,000,000. The second option is to finance in debt of $20,000,000 and $30,000,000 in
equity. The interest rate on the debt finance option is 8%.
Cherokee Plastics Corporation
Income Statement
End of 1st year Profits
(Option 1: Equity) (Option 2: Equity & Debt)
Income before interest & taxes $5,000,000 $5,000,000
Less: Interest Expense (8%-Option 2 only) $0 $1,600,000
Income before taxes $5,000,000 $3,400,000
Less: Tax Expenses (25%-Both Options) $1,250,000 $850,000
Net Income $3,750,000 $2,550,000
2: Highest first year profits
Option 1, financing with equity only, is expected to achieve the highest first-year profits
because there is no interest on the capital. The benefit of an equity-only financing option is there
is no interest expense on the capital investment, but you do not keep as many profits as the
equity and financing option (Maverick, 2019). This allows for the net income to be much
higher however that does not mean that option 1 has a higher return rate than option 2 with the
interest expense included.
3: Highest rate of return on equity
Option 2, financing with a combination of equity and debt, has the higher rate of return at
5.7%. According to J.B. Maverick from Investopedia.com this option of a combination of debt
and equity financing is what most companies use to finance their startup capital (Maverick,
2019).
(Option 1: Equity) (Option 2: Equity & Debt)
$2,500,000/$50,000,000 = 5% return rate $1,700,000/$30,000,000 =5.7% return rate
4: Highest risk option
The riskier of the two options is option 1, the debt only financing option. This option
leaves the company vulnerable because when starting the business there is no guaranteed
revenue coming in. No guarantee of revenue puts the company at risk because there is a monthly
payment obligation to the creditor that gave the loan for capital. “Equity financing places no
additional financial burden on the company. Since there are no required monthly payments
associated with equity financing, the company has more capital available to invest in growing the
business” (Maverick, 2019). The biggest downfall of equity financing is you share ownership of
the company with your investor and run the risk of “loss of control” (Cremades, 2018).
Biblical Reference
“The prudent see danger and take refuge, but the simple keep going and pay the penalty
(ESV, Proverbs 27:12)”. The less risker option is the best option for this company. There may be
penalty with taking the risker path.
References
Cremades, A. (2018, August 20). Debt vs. Equity Financing: Pros and Cons for Entrepreneurs.
Retrieved from https://www.forbes.com/sites/alejandrocremades/2018/08/19/debt-vs-
equity-financinpros-and-cons-for-entrepreneurs/#15a905cf6900
Maverick, J.B. (2019, April 19). The Difference Between Equity Financing vs. Debt Financing.
Retrieved from https://www.investopedia.com/ask/answers/042215/what-are-benefits-
company-using-equity-financing-vs-debt-financing.asp
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