Mike Bloom has just received a golden handshake of $5 million from his former partners. 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: Each dollar invested can support $3 in annual sales. 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. The corporate tax rate is 30 percent. Bloom plans to draw no income from the venture until the end of the 5th year. After that, he will 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 would contribute 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. If either debt or equity could be used to meet the objective, what other considerations should affect the choice? How might you expect issues of control and risk to bear on the decision?
a. How does the sustainable growth rate of the venture with all equity financing change under the scenario where the service is very well-received by the financial community, so that each dollar of investment can support $3.75 worth of sales and the profitability of sales is 20 percent? What does this do to the amount of equity financing that is required to achieve the objective?
b. How are your conclusions affected by a scenario in which the product is not very well received, so that each dollar of investment supports only $2.50 worth of sales and the profitability of sales is 10 percent?
c. How are your conclusions in parts (a) and (b) affected if outside debt financing is used instead of equity.
d. Do the results of the scenario analysis affect your perceptions of the relative merits of debt or equity financing in this case? If so, how, and why?