As a result of a merger, Mike Bloom has just received a golden handshake of $5 million from his former partners. Rather than taking a comfortable early retirement, he has decided to try to leverage the payment into something even more valuable. His plan is to use the money to start a new financial information service, and he is willing to invest all of the money, if necessary. His goal is to realize an annual return of $8 million per year beginning in five years. The $8 million is to be measured as his share of venture net income after tax.
Bloom expects that each dollar invested in the venture can support $3 in annual sales and that the before-tax return on sales will average 15 percent per year if only equity financing is used. Debt financing is expected to cost 8 percent per year, and the corporate tax rate is 30 percent. Bloom plans to draw no investment income from the venture until the end of the fifth year. After that, he expects to be able to take his share of net income as a distribution each year.
a. Can Bloom achieve his return objective by using debt financing? If so, what capital structure policy (with stable leverage ratio) will enable him to do so?
b. Suppose an outside investor is interested in participating in the venture by contributing equity capital at the initiation of the venture. Doing so would enable the venture to start up on a larger scale. The investor wants 1 percent of total equity in exchange for each $250,000 of investment. Can Bloom achieve his objective using outside equity financing? If so, how much outside financing is needed?
c. In the event that either debt or equity could be used to meet the objective, what other considerations should affect the choice? In particular, how might you expect issues of control and risk to bear on the decision?