John Castillo
MT480
Chapter 8
5/17/22
Debt-Financing
Debt-Financing is the method of financing capital structure by selling debt instruments to
investors. This can include selling products such as bills, bonds, or notes.
Tax benefits of debt financing
Debt-Financing helps companies or businesses acquire funds for capital structures by providing a
tax shield. Some of the advantages include retaining ownership, interest payments that are taxdeductible, and helping build a business’s credit score. Interest is also incurred as an expense
which then creates a tax shield.
Problem
The problem states that the entrepreneur is requiring $100,000 to purchase a diagnostic machine
for a healthcare facility and would like to maintain as much equity as possible. As an angel
investor, it is required to be financed with 60% debt and 40% equity. The cost of equity is 16%
and the cost of debt 9%. Based on year 1 sales projections the return of investment will be 9%
and will cover the first year’s pretax cost of debt and allow for equity growth and refinancing for
the second year. We will use an after-tax weighted average cost of capital model, which includes
the after-tax cost of debt and proportionate cost of debt versus equity with a 35% marginal tax
rate applied.
Solution
Cost of equity (Ke) = 16%
Pre-tax cost of debt (Kd) = 9% (pre-tax)
Marginal Tax rate = 35%
Debt proportion (Wd) = 60%
Equity (We) = 40%
Expected return of investment (ROI) = 9%
AT-WACC = (wd) x (Kd) + (We) x (Ke)
60% x 9% + 40% x16% = 0.6
(We) = 0.4
(Ke) = 0.16
9% (1-0.35) = 5.85%
AT-WACC = 0.6 x 5.85 + 0.40 x 16
3.51 + 6.4
AT-WACC = 9.91 %
Since the return of investment is 9%, this would not be a good investment as the cost of
financing would be greater. The WACC needs to be less than 9%.
Reducing the AT-WACC requires increasing the proportion of debt in the project. Assuming
75% debt and 25% equity:
AT-WACC = 0.75 x 5.85 + 0.25 x 16
AT-WACC = 8.39%
In this instance, the AT-WACC is less than 9% and would create a better investment.
Conclusion
According to the original AT-WACC of 9.91%, this would create more debt and would result in
the business going bankrupt.
The role of the UCC-1 document in debt-financing is to show that creditors have priority over
debtors in cases of bankruptcy, and help clarify the collection process during these proceedings if
necessary. Overall this would not be a good investment with the original AT-WACC of 9.91%
Sources:
Parrino R., Kidwell D. S., Bates T., & Gillan S. L. (2017). Fundamentals of Corporate Finance.
[VitalSource Bookshelf]. Retrieved from
https://bookshelf.vitalsource.com/#/books/9781119371434/
What Is a UCC-1 Statement? (2021, December 1). Investopedia. Retrieved May 17, 2022, from
https://www.investopedia.com/terms/u/ucc-1-statement.asp#:%7E:text=Key%20Takeaways,A%20UCC%2DUniform%20Commercial%20Code%2D1%20statement%20is%20a%20legal,in
tent%20to%20seize%20collateralized%20assets.