{"id":21766,"date":"2020-01-08T18:47:40","date_gmt":"2020-01-08T23:47:40","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/biws\/?post_type=biws_kb&#038;p=21766"},"modified":"2024-12-29T23:13:32","modified_gmt":"2024-12-30T04:13:32","slug":"debt-vs-equity-analysis","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/debt-equity\/debt-vs-equity-analysis\/","title":{"rendered":"Debt vs. Equity Analysis: How to Advise Companies on Financing"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">Debt vs. Equity Analysis: How to Advise Companies on Financing<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/debt-equity\/debt-vs-equity-analysis\/#Debt_vs_Equity_Analysis_The_short_answer\">Debt vs. Equity Analysis: The short answer<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/debt-equity\/debt-vs-equity-analysis\/#The_Step-by-Step_Process\">The Step-by-Step Process<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/debt-equity\/debt-vs-equity-analysis\/#Real-Life_Example_%E2%80%93_Central_Japan_Railway\">Real-Life Example \u2013 Central Japan Railway<\/a><\/li><\/ul><\/nav><\/div>\n\n<style><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span>.enteremail__large--inline{margin:60px auto!important}<\/style>\n<p>If you have an upcoming case study where you have to analyze a company&#8217;s financial statements and recommend Debt or Equity, how should you do it?<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Debt_vs_Equity_Analysis_The_short_answer\"><\/span>Debt vs. Equity Analysis: The short answer<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>All else being equal, companies want the cheapest possible financing. Since Debt is almost always cheaper than Equity, Debt is almost always the answer.<\/p>\n<p>Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders&#8217; expected returns are lower than those of equity investors (shareholders).<\/p>\n<p>The risk and potential returns of Debt are both lower.<\/p>\n<p>But there are also constraints and limitations on Debt \u2013 the company might not be able to exceed a certain Debt \/ EBITDA, or it might have to keep its EBITDA \/ Interest above a certain level.<\/p>\n<p>So, you have to test these constraints first and see how much Debt a company can raise, or if it has to use Equity or a mix of Debt and Equity.<\/p>\n<div class='code-block code-block-2' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/04\/24164120\/adv-fm-tile.png\" alt=\"PowerPoint Pro\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Financial Modeling for Investment Banking With <strong>BIWS Core Financial Modeling<\/strong><\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Become a financial modeling pro<\/h4>\n              <p>158 videos, detailed written guides, Excel files, quizzes, and more<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 10+ detailed global case studies<\/h4>\n            <p>These include both the theory and the practical applications<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Prepare for your internship or full-time job<\/h4>\n            <p>Gain the skills you need to \u201chit the ground running\u201d on Day 1\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/core-financial-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Core-Financial-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div><\/div>\n\n<h2><span class=\"ez-toc-section\" id=\"The_Step-by-Step_Process\"><\/span>The Step-by-Step Process<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p><strong>Step 1:<\/strong> Create different operational scenarios for the company \u2013 these can be simple, such as lower revenue growth and margins in the Downside case.<\/p>\n<p><strong>Step 2:<\/strong> &#8220;Stress test&#8221; the company and see if it can meet the required credit stats, ratios, and other requirements in the Downside cases.<\/p>\n<p><strong>Step 3:<\/strong> If not, try alternative Debt structures (e.g., no principal repayments but higher interest rates) and see if they work.<\/p>\n<p><strong>Step 4:<\/strong> If not, consider using Equity for some or all of the company&#8217;s financing needs.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Real-Life_Example_%E2%80%93_Central_Japan_Railway\"><\/span>Real-Life Example \u2013 Central Japan Railway<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>The company needs to raise \u00a51.6 trillion ($16 billion USD) of capital to finance a new railroad line.<\/p>\n<p><strong>Option #1:<\/strong> Additional Equity funding (would represent 43% of its current Market Cap).<\/p>\n<p><strong>Option #2:<\/strong> Term Loans with 10-year maturities, 5% amortization, ~4% interest, 50% cash flow sweep, and maintenance covenants.<\/p>\n<p><strong>Option #3:<\/strong> Subordinated Notes with 10-year maturities, no amortization, ~8% interest rates, no early repayments, and only a <a href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/debt-service-coverage-ratio\/\" target=\"_blank\" rel=\"noopener\">Debt Service Coverage Ratio (DSCR)<\/a> covenant.<\/p>\n<p>We start by evaluating the Term Loans since they&#8217;re the cheapest form of financing.<\/p>\n<p>Even in the Base Case, it would be almost impossible for the company to comply with the minimum DSCR covenant, and it looks far worse in the Downside cases<\/p>\n<p>Next, we try the Subordinated Notes instead \u2013 the lack of principal repayment will make it easier for the company to comply with the DSCR.<\/p>\n<p>The DSCR numbers are better, but there are still issues in the Downside and Extreme Downside cases.<\/p>\n<p>So, we decide to try some amount of Equity as well. We start with 25% or 50% Equity, which we can simulate by setting the EBITDA multiple for Debt to 1.5x or 1.0x instead.<\/p>\n<p>The DSCR compliance is much better in these scenarios, but we still run into problems in Year 4.<\/p>\n<p>Overall, though, 50% Subordinated Notes \/ 50% Equity is better if we strongly believe in the Extreme Downside case; 75% \/ 25% is better if the normal Downside case is more plausible.<\/p>\n<p>Qualitative factors also support our conclusions.<\/p>\n<p>For example, the company has extremely high EBITDA margins, low revenue growth, and stable cash flows due to its near-monopoly in the center of Japan, so it&#8217;s an ideal candidate for Debt.<\/p>\n<p>Also, there&#8217;s limited downside risk in the next 5-10 years; population decline in Japan is more of a concern over the next several decades.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>In this tutorial, you&#8217;ll learn how to analyze Debt vs. Equity financing options for a company, evaluate the credit stats and ratios in different operational cases, and make a recommendation based on both qualitative and quantitative factors.<\/p>\n","protected":false},"featured_media":0,"template":"","class_list":["post-21766","biws_kb","type-biws_kb","status-publish","hentry","kb_category-debt-equity"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/21766","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=21766"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}