John Dalton is well on his way to starting a new venture— Max, Inc. He has projected a need for $350,000 in initial capital. He plans to invest $150,000 himself and either borrow the additional $200,000 or find a partner who will buy stock in the company. If Dalton borrows the money, the interest rate will be 6 percent. If, on the other hand, another equity investor is found, he expects to have to give up 60 percent of the company’s stock. Dalton has forecasted earnings of about 16 percent in operating profits on the firm’s total assets.
Using the following questions as a guide, what would be your recommendation?
1. Compare the two financing options in terms of projected return on the owner’s equity investment. Ignore any effect from income taxes.
2. What if Dalton is wrong and the company earns only 4 percent in operating profits on total assets?
3. What should Dalton consider in choosing a source of financing?